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government cannot afford in the long run to ignore sound economic principles in determining net income. Perhaps the greatest share of the trouble is due to the action of incompetent inspectors who sometimes arbitrarily insist upon a reduction of reserves to insufficient amounts. Fortunately their action is rarely sustained by the officers of the Treasury, whose recent attitude in the matter of depreciation and depletion has been in accord with good accounting practice.

Applicability of rates of depreciation used in prior years.Taxpayers who use substantial rates of depreciation are sometimes embarrassed by examiners who apply the rates used in 1917 and 1918 to their plant accounts for many years prior. It may turn out that a literal application of the rates will practically wipe out the plant account at January 1, 1917, and thus greatly reduce the allowable invested capital for excess and war profits purposes.

The method, of course, is inaccurate and falls of its own weight. In most cases it is possible to prove that on January 1, 1917, the actual value of the plant, without taking appreciation into consideration, greatly exceeded the theoretical valuation. Such result does not in itself prove that because the rates are incorrect as applied to prior years they are also incorrect as applied to 1917 and 1918.

The rates are incorrect as applied to prior years because during those years the renewals, repairs, maintenance and capital outlays charged to operations greatly reduced the reserve necessary to reflect accurately the net going value of the plant on the books of account.

One concern charging high depreciation rates for 20 years prior to 1917 might show the same net plant values at the end of the period as a concern which charged off no depreciation, as such, during the entire period.

Prior to 1917 it made little difference to many concerns what rates of depreciation were charged.

Furthermore, during 1917 and 1918 there were good reasons for greatly increasing depreciation rates over those formerly used.

The British War Ministry cannot be charged with holding a brief for American manufacturers; therefore the rates of depreciation suggested in official memoranda of the War Ministry are of great interest as having direct bearing on conditions in the United States.

When normal rates of depreciation on machinery were 77/2 per cent per annum it was suggested that there be allowed the following additions :

Addition for unskilled labor up to 50%........ 374%
Addition for overtime........ ............ 1114

Total additions ...................... 15%
Normal rate ................................ 77/2

Total ... .......................... 2212%
Maximum allowance ......................... 25%

Engineers of the War Department of the United States reported that the British additional rates were too liberal and recommended that the maximum to be used in the foregoing example be fixed at 15 per cent.

Taxpayers whose accounts are being examined should give careful attention to the actual conditions during 1917 and 1918 and when special depreciation was warranted by existing conditions, as compared with previous practice, they should insist on proper allowances.

Conditions Precedent to Allowance for Depreciation

The general provision in the regulations which sets forth the conditions which must be met before a deduction for depreciation is allowed reads as follows:

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 covering depreciation, excluding from the term any idea of a mere reduction in market value

ue, at the. or its date.

not resulting from exhaustion, wear and tear or obsolescence. The proper allowance for such depreciation of any property used in the trade or business is that amount which should be set aside for the taxable year in accordance with a consistent plan by which the aggregate of such amounts for the useful life of the property in the business will suffice, with the salvage value, at the end of such useful life to provide in place of the property its cost, or its value as of March 1, 1913, if acquired by the taxpayer before that date. .... (Art. 161.)

It is proper that taxpayers should adopt a consistent plan and they should adhere to it until actual conditions call for a change. If it is calculated that machinery depreciates a given percentage under certain conditions, it is not inconsistent to change the percentage when conditions change.

Property depreciated must not be for personal use.

REGULATION. .... The deduction of an allowance for depreciation is limited to property used in the taxpayer's trade or business. . . . . (Art. 162.)

To quote the language of the Primer, “depreciation in the value of a home or any article of property, such as automobiles, used for personal pleasure or convenience, cannot be claimed; the property must be used for the purpose of producing income.” In the case of the farmer the regulations expressly permit depreciation on all farm buildings “other than a dwelling occupied by the owner."0

Depreciation of residence.—When a residence is used part of the year by the owner and is rented for part of the year, depreciation will be an allowable deduction for the period of the year when used for income-producing purposes. The depreciation is not necessarily based on the proportion of time during which the property is rented, as the actual depreciation during such time may be greater than during the time of occupancy by the owner. If the taxpayer owns a summer cottage and rents it for three months during the summer and

"Income Tax Primer, 1918, question 99, Art. 171, see Chapter XXXVI,

occupies it personally during one month, it may be that the entire annual depreciation should be deducted as the facts would indicate that the property as a whole is held for income-producing purposes and the occupancy by the owner for a short period is merely incidental. The test, however, would be the actual circumstances in each case.

RegulaTION. . . . . No such allowance may be made in respect of .... building used by the taxpayer solely as his residence, nor in respect of furniture or furnishings therein, personal effects, or clothing; .... (Art. 162.)

Property which may be depreciated.?—

REGULATION. The necessity for a depreciation allowance arises from the fact that certain property used in the business gradually approaches a point where its usefulness is exhausted. The allowance should be confined to property of this nature. In the case of tangible property, it applies to that which is subject to wear and tear, to decay or decline from natural causes, to exhaustion, and to obsolescence due to the normal progress of the art or to becoming inadequate to the growing needs of the business. It does not apply to inventories or to stock in trade; nor to land apart from the improvements or physical development added to it. It does not apply to bodies of minerals which through the process of removal suffer depletion, other provision for this being made in the statute. .... (Art. 162.)

Replacements and renewals must not be twice deducted." -Expenditures for the upkeep of property range by imperceptible gradations from the most insignificant repairs to the

*For depreciation of land, see page 719.

For depreciation of farm buildings, equipment and livestock, see Chapter XXXVI, "Farmers."

[British Practice] The following general instructions governing replacements and renewals have been issued by the Inland Revenue Department of Great Britain:

"In all cases where depreciation allowances are granted, renewals, if charged against revenue, shall be carefully distinguished and notified to the surveyor in order that they may be added back to profits for the purpose of arriving at the income tax liability.

"If new works are erected, wholly or partially, on a new site, in place of old works abandoned or demolished, a reasonable allowance shall be granted for renewals in respect of the displaced plant, so far as it is actually renewed, such allowance to have regard to the original cost of the displaced plant, less any depreciation that may have been

replacement of the largest and most costly units. The law, of course, intends that all such expenditures shall be deducted, but the necessity arises of distinguishing between those which shall be deducted annually as expenses and those for which provision shall be made through cumulative depreciation allowances. In making this distinction, care must be taken to avoid the double deduction of expenses. The problem is complicated by the fact that, minor repairs are made upon the most expensive machines. While theoretically it may be conceivable that depreciation rates might under some conditions be so delicately adjusted as to provide completely and perfectly for the entire upkeep of a machine or other piece of property, as a practical matter it is so difficult as to be impossible. The accountant's solution is to draw a somewhat arbitrary line between the small incidental items of repair, replacement and maintenance and the heavy items of renewal and replacement, charging the first group to expense and the second to depreciation reserves. The depreciation rates are calculated with this assumption in mind and consequently depreciation reserves should be kept free from charges except those for unquestioned renewals or replacements of major parts. The regulations satisfactorily cover this point in the following statement.

REGULATIONS..... Property kept in repair may, nevertheless, be the subject of a depreciation allowance. .... (Art. 162.)

granted, but such allowance shall not include the cost of preparing the new site or erecting foundations for the new plant.

"All renewals of parts which do not destroy the identity of the original article shall be allowed as repairs, except so far as they constitute an extension, enlargement, or other similar improvement in value.

"Where renewals are allowable under this scheme in lieu of depreciation, they shall be allowed notwithstanding that the cost thereof may not have been debited in the company's accounts against revenue.

"Written down value means original prime cost, plus subsequent additions (including renewals which have not been allowed for income tax purposes) less all allowances actually granted for income tax purposes in past years in respect of depreciation.

"Expenditure includes the sum expended on materials, labor, and incidentals."

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