Opinion
Docket No. 5406.
Promulgated May 3, 1946.
In 1928, petitioner leased buildings and land from the Ford Motor Co. On September 10, 1936, petitioner executed a written lease first expiring on December 31, 1938. The lease was renewed and extended each year thereafter for a 12-month period, with modifications in area and buildings occupied. During 1936 and 1937 petitioner expended $97,916.02 for installing its seamless tube mill and auxiliary equipment, including foundations, and capitalized such costs on its books. During the same years, petitioner also expended $18,960.25 for foundations and installation costs pertaining to machinery and equipment other than its seamless tube mill and capitalized such costs on its books. Held, that by reason of petitioner's tenancy for an indefinite period and of the fact that the expenditures were related and thus attached to the machines themselves, the allowance for the exhaustion of the cost of such expenditures should be based on the useful life of such machinery to which the expenditures were related.
Meredith M. Daubin, Esq., for the petitioner.
A. J. Friedman, Esq., for the respondent.
The respondent determined deficiencies of $21,235.83 and $25,159.13 in the petitioner's income and excess profits taxes, respectively, for the year 1941.
The basic issue is whether certain items expended by the petitioner and capitalized on its books as a part of the installation and foundation costs of machinery should be amortized over the term of the lease of the premises which the petitioner was then occupying, or should be depreciated over the useful life of the machines.
A minor issue involves the proper depreciation of the foundation and installation costs of machinery other than that of the petitioner's seamless tube mill.
FINDINGS OF FACT.
The facts were stipulated. The portions thereof material to the issues are as follows:
The petitioner is a Michigan corporation, with its principal office in Highland Park, Michigan. It filed its income and excess profits tax returns for the year 1941 with the collector of internal revenue for the district of Michigan.
During the years 1936 and 1937 the petitioner expended $97,916.02 for materials, labor, and other items for the purpose of installing its seamless tube mill and auxiliary equipment, including foundations. That amount was capitalized on its books. Such amount is properly classified as follows:
Seamless tube mill foundation costs .......... $49,000.00 Seamless tube mill installation costs ........ 48,916.02 ---------- Total .................................... 97,916.02
Depreciation claimed and allowed on the total cost of $97,916.02 up to January 1, 1939, totaled $17,254.56 and depreciation at the same rate from January 1, 1939, to the date of the sale of the seamless tube mill and auxiliary equipment, June 6, 1939, amounted to $4,300.65. The total of these two amounts, $21,555.11, was credited on the petitioner's books to its depreciation reserve account. This amount of depreciation as computed by the petitioner is allocated as follows:
Depreciation Total Depreciation for the depreciation Net Book Cost to the period to value at Jan. 1, 1939 Jan. 1 to June 6, June 6, June 6, 1939 1939 1939 Seamless tube mill foundation costs ...... $49,000.00 $8,634.63 $2,152.17 $10,786.80 $38,213.20 Seamless tube mill installation costs ...... 48,916.02 8,619.83 2,148.48 10,768.31 38,147.71 ---------- --------- --------- ---------- ---------- Total .... 97,916.02 17,254.46 4,300.65 21,555.11 76,360.91 The seamless tube mill foundation costs consisted of amounts expended for various types of material and labor required to construct specially-designed foundations for the seamless tube mill and auxiliary equipment. These foundations had no useful value to the petitioner in connection with its business and operations other than in connection with the operation of the seamless tube mill and auxiliary equipment.The seamless tube mill and auxiliary equipment were sold on June 6, 1939, and a loss was sustained and claimed on the Federal income tax return for 1939. The petitioner claimed as a part of the cost basis of the seamless tube mill the depreciated cost shown by its books as of June 6, 1939, of the seamless tube mill foundation and installation costs in the said amount of $76,360.91. The petitioner also claimed the amount of $4,300.65 as a deduction for the year 1939 for depreciation. The petitioner included these two amounts in the 1939 net loss carryover and claimed such carry-over loss as a deduction on its Federal income tax return filed for the year 1941.
In his notice of deficiency the Commissioner disallowed as a part of the cost basis of the seamless tube mill and auxiliary equipment the amount of $76,360.91 and he also disallowed as a deduction the depreciation claimed in the amount of $4,300.65. His action resulted in decreasing the net loss carry-over from the calendar year 1939 to the calendar year 1941 by these same two amounts, $76,360.91 and $4,300.65, and he disallowed these two amounts as a deduction in his computation of net taxable income for the calendar year 1941.
During the years 1936 and 1937 the petitioner expended $18,960.25 for foundations and installation costs pertaining to machinery and equipment other than the seamless tube mill. That amount was capitalized on its books. Such amount is properly classified as follows:
Foundation costs specially designed to support machinery and equipment .......................... $13,660.77 Installation costs of machinery and equipment .... 5,299.48 ---------- Total ........................................ 18,960.25
Depreciation on the foundation costs was recorded on the petitioner's books and claimed as deductions on the petitioner's Federal income tax returns for the years 1939, 1940, and 1941 in the respective amounts of $1,349.26, $1,296.38, and $1,296.34. These depreciation deductions have been disallowed by the Commissioner.
Depreciation on the installation costs was recorded on the petitioner's books and claimed as a deduction on the petitioner's Federal income tax returns for the years 1939, 1940, and 1941 in the respective amounts of $309.12, $529.93, and $529.92. These depreciation deductions have also been disallowed by the Commissioner.
It was agreed and stipulated that if depreciation is determined to be allowable for the years 1939, 1940, and 1941 with respect to foundation costs in the amount of $13,660.77, the amount allowable shall be the amounts of $1,349.26, $1,296.38, and $1,296.34 for such respective years and that if depreciation is determined to be allowable for the years 1939, 1940, and 1941 with respect to installation costs in the amount of $5,299.48, the amount allowable shall be the amounts of $309.12, $529.93, and $529.92 for such respective years.
Since 1928 the petitioner has occupied premises at Highland Park, Michigan, leased from the Ford Motor Co. The buildings in which were located the seamless tube mill and auxiliary equipment and other machinery hereinabove mentioned, and the foundations to support them, have been occupied continuously by the petitioner since 1936 to date (September 19, 1945) under a written lease executed September 10, 1936, for a period first expiring December 31, 1938. This lease has been renewed and extended each year for a twelve-month period, with modifications in area and buildings occupied.
In an agreement captioned "RENEWAL LEASE AGREEMENT," dated December 31, 1944, the last of the series of such renewal agreements, as stipulated in the record, appears the following provision:
Lessee acknowledges its obligation to restore these buildings to their former condition and to remove the foundations constructed by Lessee therein, and agrees to so restore the premise in any areas vacated, immediately upon request from Lessor so to do.
In the agreement of September 10, 1936, appears the following provision:
In event Lessee shall hold over after the expiration of the term demised for a sufficient period of time to create a renewal of this lease by operation of law, any renewal or future right of possession not evidenced by an instrument in writing, executed and delivered by Lessor, shall be a tenancy from calendar month to calendar month and for no longer term, at the monthly rental of $1,500.00.
Similar provisions were incorporated in subsequent supplemental agreements and renewals.
In his notice of deficiency the Commissioner disallowed the item of $76,360.91 with the following explanation:
It is held in determining the operating loss for the year 1939 to be carried forward to subsequent years the allowable loss on the sale in the year 1939 of your seamless tube mill is $218,879.68. The additional loss claimed in the amount of $76,360.91 has not been allowed for the reason that it is not considered to be a proper part of the undepreciated cost of the assets sold or otherwise disposed of which is to be used in determining the loss sustained on the seamless tube mill.
and disallowed the items relating to the machinery and equipment other than the seamless tube mill, on the following ground:
Depreciation claimed for the years 1939, 1940 and 1941 on the cost of improvements to leased property, other than costs of installation of the seamless tube mill, captioned "Heating System-Installation Cost and Building Improvements" has not been allowed for the reason that these improvements are held to have been fully depreciated prior to December 31, 1938.
In settling the petitioner's tax liability for the years 1936, 1937, and 1938 the Commissioner disallowed depreciation on the items capitalized at $97,916.02, as above set forth, on the basis of a ten-year useful life of the seamless tube mill. In computing the loss from the sale of the seamless tube mill the Commissioner designated such items as "Improvements to Leased Property."
OPINION.
The major question at issue is whether certain expenditures made by the petitioner for foundations and installation costs of machinery should be amortized over the term of the lease under which it was then occupying and using buildings and land for its plant purposes, or should be depreciated over the useful life of the machines.
The respondent's position is that the period of amortization is confined strictly to the term of the original leases expiring on December 31, 1938, and that therefore the entire amount of the expenditures in controversy should have been amortized by that date, regardless of the petitioner's conception of its rights at the time and its corresponding book entries. Hence, he concludes, there remain no unamortized or undepreciated costs which can be included in the petitioner's carry-over of loss to its income tax return for 1941. The petitioner contends that the proper basis for depreciation is the useful life of the machinery to which the expenditures related.
On the assumption that the sums expended for foundation and installation operations resulted in permanent improvements, the respondent's view might be correct if the record contained only the amounts expended by the petitioner in 1936 and 1937 and the "original" leases expired on December 31, 1938. In that case a definite tenancy would have been established and the improvements to the real estate made by the tenant would have been amortizable over the term of the lease.
However, the facts before us do not support the respondent's theory. The petitioner first became a tenant of the Ford Motor Co. in 1928. No leases prior to those directly involved in the present issue have been presented. The petitioner has continued to occupy the same land and buildings, with minor modifications of rental and floor space, until the present time. Incorporated in the September 10, 1936, lease were detailed provisions governing the covenants between the lessor and lessee. Supplemental and renewal lease agreements specifically recognized such primary provisions.
The paragraph in the September 10, 1936, agreement relating to a "holdover" by the lessee clearly contemplated a renewal "by an instrument in writing" but created a tenancy from month to month if such an instrument should not have been executed. The renewal agreement for the year 1939, executed on January 11, 1939, shows that it was after the expiration date of the original lease but well within the period specified in the paragraph.
The seamless tube mill and auxiliary equipment were sold on January 6, 1939, over five months after the expiration of the "original" lease and during the period of its renewal or extension. The date of the sale is significant in that it confirmed the fact that both the lessor and the lessee intended to continue the tenancy indefinitely — certainly beyond December 31, 1938. It is not reasonable to assume that the expenditure of well over $100,000 would have been made upon the basis of a depreciation or amortization period of only twenty-seven months.
The picture thus portrayed makes the situation subject to the rule that where the tenancy of the lessee is for an indefinite period the allowance for exhaustion of the cost of improvements should be based upon the life of the improvements. Rankin v. Commissioner, 60 F.2d 76, affirming 17 B. T. A. 1301; Sentinel Publishing Co., 2 B. T. A. 1211; cf. Bowman Co. v. Commissioner, 32 F.2d 404, affirming 7 B. T. A. 399; Thatcher Medicine Co., 3 B. T. A. 154; Wm. Greilich Sons, Inc., 3 B. T. A. 1333; Elmira Arms Co., 7 B. T. A. 703.
In Bowman Co. v. Commissioner, supra, the court stated:
* * * We are of opinion that the period of the lease is not controlling where it is shown that the tenancy extended for a period substantially beyond the taxable year in which the adjustment for the improvements is claimed. In the present case the tenancy was still continuing at the time the stipulation was made in 1927, and, for ought that appears in the record, it is still in existence. It may well be that, if the tenancy had terminated prior to or at the end of the taxable year, a different case would be presented; but the taxing authorities are not confined to any fixed or rigid rule in applying the statute, since each case must depend largely upon its own facts. * * *
The facts in the case at bar show that during the period of expenditure the petitioner was reasonably certain that its lease would be renewed, but that no definite term thereof was fixed or indicated. Therefore, the costs of such foundation and installation expenditures are depreciable over their useful life (see Regulations 111, sec. 29.23 (a)-10, governing unexercised renewal options — a situation somewhat similar to that appearing here).
The question now arises, Were the costs of building the foundations and installing the machines in both the seamless tube mill and other operations of the petitioner, a part of the costs of such machines? The answer is obvious. Bulletin "F" (Revised January 1942) of the Treasury Department states on page 2:
* * * The cost of installation, as well as the freight charges thereon, are capital expenditures to be added to the cost of the property recoverable through depreciation deductions.
See Rankin v. Commissioner, supra.
The petitioner maintains that the foundations for the machines were improperly classified by the respondent as "building improvements." We agree. The stipulation specifically states:
The seamless tube mill foundation costs consisted of amounts expended for various types of material and labor required to construct specially-designed foundations for the seamless tube mill and auxiliary equipment. These foundations had no useful value to the petitioner in connection with its business and operations other than in connection with the operation of the seamless tube mill and auxiliary equipment.
(See also C. B. I-1, p. 196, IT 1309.)
The facts that the foundations were specially designed and adapted to the seamless tube mill (which was dismantled and sold in 1939) and to the machinery and equipment other than the seamless tube mill and that all such expenditures were capitalized on the petitioner's books demonstrate that they were essentially integral parts of the machines and were so treated and considered. It is logical and proper, therefore, to allow depreciation on the same basis and at the same rate as those applicable to the machines for which the foundations were built and to which the installation costs pertained.
The cases cited and relied upon by the respondent, 379 Madison Avenue, Inc. v. Commissioner, 60 F.2d 68, and Fackler v. Commissioner, 133 F.2d 509, were decided on facts quite dissimilar to those stipulated here and consequently are not in point.
Recomputation of the petitioner's tax liability will be made pursuant to the figures stipulated.
Decision will be entered under Rule 50.