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The Treasury prior to 1918 allowed as deductions realized obsolescence. As such deductions could have been made as losses, whether or not obsolescence as such was specified in the law the reason for the specific mention of obsolescence in the 1918 law was apparently to permit the accrual of obsolescence.

Under the most recent rulings so-called "ordinary obsolescence,” viz., that obsolescence which is accruing but which cannot be definitely ascertained, is to be included in the annual depreciation allowances rather than in a specific reserve for obsolescence.

The allowance for "accruing" obsolescence as distinguished from that which has "accrued" 1 is stated in the following new regulation.

REGULATION. With respect to physical property the whole or any portion of which is clearly shown by the taxpayer as being affected by economic conditions that will result in its being abandoned at a future date prior to the end of its normal useful life, so that depreciation deductions alone are insufficient to return the cost (or other basis) at the end of its economic term of usefulness, a reasonable deduction for obsolescence, in addition to depreciation, may be allowed in accordance with the facts obtaining with respect to each item of property concerning which a claim for obsolescence is made. No reduction for obsolescence will be permitted merely because, in the opinion of a taxpayer, the property may become obsolete at some later date. This allowance will be confined to such portion of the property on which obsolescence is definitely shown to be sustained and can not be held applicable to an entire property unless all portions thereof are affected by the conditions to which obsolescence is found to be due. (Art. 166.)

'For "accrued" obsolescence or "loss of useful value," see Art. 143, page 1171.

In actual practice, it has not been possible, except in rare instances, to convince revenue agents that the depreciation rate should have added to it a percentage to take care of "accruing obsolescence." In most cases this has been true because the manufacturer himself has had a somewhat hazy idea as to how accruing obsolescence could be estimated, and has not had collected all the facts which are obtainable to show that such obsolescence, while not obvious, is nevertheless a very real thing which he is entitled to deduct in computing net income.

Federal income tax laws prior to 1918 contained no reference to obsolescence and amortization but conditions in 1918 required that explicit authority should be given to the Treasury to grant, and to taxpayers to deduct, adequate allowances for losses which might not otherwise be permitted.

The sudden end of the World War in 1918 is responsible for many problems which have not yet been solved. All taxpayers who increased their plant facilities prior to November, 1918, whether or not for strictly war purposes and who had claimed amortization on their original returns were required to make their decision regarding the effect of post-war conditions prior to March 3, 1924.

Facilities of any kind "for the production of articles contributing to the prosecution of the present war" if acquired or constructed after April 6, 1917, were, under the 1918 and 1921 laws, the subject of a special deduction for amortization. This amortization deduction has been eliminated in the 1924 law, but taxpayers nevertheless are entitled [under section 234 (a-7)] to “a reasonable allowance for the exhaustion, wear and tear of property used in the trade or business, including a reasonable allowance for obsolescence."

The author believes that sufficient consideration has not been given to the extraordinary cost of facilities acquired after 1915, the extraordinary wear and tear of all facilities during 1917 and 1918, and the extraordinary diminution in value of such facilities under post-war conditions. When claims for amortization allowances under section 234 (a-8) of the 1918 and 1921 laws are rejected on technicalities, it may be found that equivalent deductions may be made under section 234 (a-7).

REGULATION. A reasonable allowance for the exhaustion, wear and tear, and obsolescence of property used in the trade or business may be deducted from gross income. For convenience such an allowance will usually be referred to as depreciation, excluding from the term any idea of a mere reduction in market value not resulting from exhaustion, wear and tear, or obsolescence. . (Art. 161.)

The foregoing regulation accords with proper accounting methods. Depreciation allowances set up by conservative concerns were always supposed to be sufficient to include adequate provision for ordinary obsolescence. It follows that in fact deductions were made for obsolescence. The law now definitely sanctions the deductions which taxpayers have been making and the Treasury has been allowing for some years.

In viewing obsolescence from the standpoint of a future loss, which nevertheless, because it can be foreseen, should be deducted. from income as accruing from year to year, the following is pertinent:

RULING. Obsolescence, of which the case here presented is typical, is not like depreciation, a matter of decrease in earning power or in absolute efficiency, but only in relative efficiency. It has its origin in the fact that although the original efficiency be maintained, yet, owing to improvements in the art or changed economic conditions, a device or factor in production will eventually have to be discarded. The loss is a future loss, but for equitable reasons the statute permits it to be spread over the period for which it can be foreseen, and allows the portion assignable to the period subsequent to December 31, 1917, to be deducted pro rata over such period.

In the instant case the vessels of the 5,000-ton class will today net x cents freight per mile, as when they were first constructed. Their intrinsic value is unimpaired, but, because the newer and larger type will earn from six to eight times as much, it is evident that, when the number of larger vessels becomes sufficient to handle the carrying trade of the Great Lakes, the smaller vessels will become economically impossible of operation and will necessarily be discarded or junked. . . (C. B. I-1, page 161; A. R. R. 963.)

Obsolescence as described above has been discussed in the preceding chapter. Obsolescence which may be said to be "realized" is considered in the following pages.

Treasury Procedure as to Obsolescence

Under previous laws the Treasury allowed as deductions reserves for depreciation, but did not allow reserves specifically for obsolescence.

Reserves for obsolescence which appeared on taxpayers' books at the beginning of the taxable year ending in 1918 were not allowable as deductions under earlier income tax laws. In order to avoid great annoyance and possible complications in the future it would. be proper in most cases to transfer obsolescence reserves as of January 1, 1918, to surplus account. Commencing with that date,

obsolescence reserves should reflect allowances claimed and allowed for income tax purposes.

The contention of the Income Tax Unit that surplus accruing in years prior to 1918 should be reduced by accruing obsolescence in those years, was overruled by the Committee on Appeals and Review.2

Obsolescence

LAW. Section 214. (a) In computing net income there shall be allowed as deductions:

3

(8) A reasonable allowance for . . . . obsolescence 3

The 1924 law does away with some of the uncertainty existing in the 1921 law as to the basis on which to compute a deduction for obsolescence. It provides in section 204 (c) for using the same basis as in the case of computing profit on sale, viz., cost or March 1, 1913, value, whichever is greater, where the property was acquired prior to March 1, 1913. In case of property acquired after March 1, 1913, cost is to be used. As in the 1921 law, the 1924 law provides that the deduction is to be "reasonable."

Mr. A. W. Gregg, special assistant to the Secretary of the Treasury, stated:

It provides that the basis of computing depreciation and depletion shall be the same as the basis of computing gain or loss from the sale of property, and represents what is obviously the correct rule, since the theory in setting a basis for depreciation and depletion is the same as in setting one for determining gain or loss from sale; that is, to insure a taxpayer a return of his capital free from tax.

Duplicate deductions must be avoided.-No well-regulated concern would charge off the same item of plant or equipment more than once, but on this point the law contains a special warning. Care must be taken that any allowances for depreciation or obsolescence claimed and allowed in returns for years prior to the taxable year be not claimed again. This, however, does not apply to amounts claimed in previous years but not allowed.

C. B. I-1, page 161; A. R. R. 963.

This section deals with individuals. Section 234 (a-7) applies the same language to corporations.

[Former Procedure] Sections 214 (a-8) and 234 (a-7) of the 1921 law provided that the deduction for obsolescence should be computed on the March 1, 1913 value where the property was acquired before that date. Where the March 1, 1913 value was less than cost this resulted in the taxpayer being deprived of the full return of his capital free from tax.

"Law, section 215 (a-3).

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