Los Angeles & Salt Lake R.R. Co.
v.
Comm'r of Internal Revenue

This case is not covered by Casetext's citator
Tax Court of the United States.Jan 30, 1945
4 T.C. 634 (U.S.T.C. 1945)

Docket No. 106462.

1945-01-30

LOS ANGELES & SALT LAKE RAILROAD COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

D. P. Kingsley, Esq., Joseph F. Mann, Esq., and Frank E. Barnett, Esq., for the petitioner. Thomas H. Lewis, Jr., Esq., for the respondent.


1. Petitioner, a railroad on the retirement method of accounting for depreciation, in the taxable year (1934) retired and wrote off specific assets which had been acquired prior to 1913. Held, under section 113, calling for ‘proper‘ adjustment to basis for depreciation, petitioner is not required to adjust its ledger ‘cost‘ to eliminate depreciation prior to 1913.

2. Losses by two of petitioner's subsidiary corporations not engaged in the railroad business which petitioner agreed to assume, held, not deductible by it as ordinary and necessary business expense. D. P. Kingsley, Esq., Joseph F. Mann, Esq., and Frank E. Barnett, Esq., for the petitioner. Thomas H. Lewis, Jr., Esq., for the respondent.

This proceeding was brought for a redetermination of declared value excess profits tax for the year 1934 in the amount of $7,701.20.

Two issues are involved. The first is whether in making deductions on the retirement of certain ways and structures the amount deducted should be reduced by the amount of depreciation ‘sustained‘ prior to March 1, 1913, petitioner being on the retirement method of accounting. The second is whether petitioner is entitled to deduct from its gross income the amounts which it paid to its subsidiaries to reimburse them for operating losses incurred in the tax year.

A stipulation of facts was filed by the parties. Facts hereinafter found which are not from the stipulation are otherwise found from t e record.

FINDINGS OF FACT.

The facts stipulated are hereby found accordingly.

Petitioner at all periods here pertinent was a corporation, organized and existing under the laws of the State of Utah. It was incorporated on March 20, 1901, and has an office at 120 Broadway, New York, 5, New York.

On or about June 15, 1935, petitioner duly filed with the collector of internal revenue for the second New York district a declared value excess profits tax return for the year 1934 which showed a deficit of $301,573.02 in income.

In 1934 the railroad lines of the Union Pacific System were owned and operated by Union Pacific Railroad Co., hereinafter called Union Pacific, and four affiliated railroad companies, Oregon Short Line Railroad Co. (hereinafter called Short Line), Oregon-Washington Railroad & Navigation Co. (hereinafter called Navigation Co.), the St. Joseph & Grand Island Railroad Co. (hereinafter called St. Jo), and petitioner. The main lines owned and operated by Union Pacific extended from Council Bluffs, Iowa, to Ogden, Utah, and from Kansas City, Missouri, through Denver, Colorado, to Cheyenne, Wyoming. Main lines owned and operated by Short Line extended from a connection with the main line of Union Pacific at Granger, Wyoming, to Huntington, Oregon, and from Salt Lake City, Utah, northerly to Butte, Montana. The main lines owned and operated by petitioner extended from a connection with the main line of Short Line at Salt Lake City, Utah, to Los Angeles, California. The main lines owned and operated by Navigation Co. extended from a connection with the main line of Short Line at Huntington, Oregon, through Portland, Oregon, to Seattle, Washington, and from Pendleton and Umatilla, Oregon, to Spokane, Washington. The main line of St. Jo extends from St. Joseph, Missouri, northwesterly to a connection with Union Pacific at Grand Island, Nebraska.

During the period here pertinent Union Pacific was a corporation organized and existing under the laws of Utah; Short Line was a corporation organized and existing under the laws of Utah, and all of its capital stock was owned by Union Pacific; and the capital stock of petitioner was owned half by Short Line and half by Union Pacific.

For the calendar year 1934 Union Pacific, on behalf of itself, petitioner, Short Line, and certain other railroad companies affiliated with Union Pacific, filed a consolidated income tax return and accordingly no deficiency in petitioner's income tax liability for that year is in issue in this proceeding.

In 1934 petitioner retired from service certain of its ways and structures. Consistent with its accounting practice in all prior years, it claimed in its return, either by way of charges to operating expenses or to surplus, deductions on account of such retirement representing the cost of the property retired, reduced only by the value of the salvage recovered therefrom. Depreciation occurred prior to March 1, 1913, with respect to the assets which petitioner retired in 1934, and the parties stipulate that if material the amount thereof may be taken to be $88,694.34.

The retirement method of accounting for ways and structures is recognized and generally employed in the railroad industry in keeping books of account and in computing net income. Respondent has never objected and still does not object to the use of the retirement method of accounting with respect to ways and structures.

The units of ways and structures of a going railroad do not constitute separate properties held primarily for sale, but their component parts in their aggregate and with the right of way constitute the railroad as a single composite property. The replacement of individual units of ways and structures in whole or in part is a continuing necessity for the maintenance and operation of the railroad in an efficient condition. Petitioner's road was completed in 1905 and prior to March 1, 1913, petitioner was a well maintained and growing railroad. The ways and structures of petitioner through all years 1913 to 1934 were growing in dollar amount.

The accounting regulations prescribed by the Interstate Commerce Commission for petitioner and other steam railroads effective since July 1, 1914, called for an election in the method of accounting for depreciation, and permitted continuance of the use of the existing retirement method of accounting, with no deductions from income for current depreciation. The accounting regulations of the Interstate Commerce Commission in effect prior to July 1, 1914, did not require depreciation to be charged with respect of ways and structures and petitioner did not in its accounts charge any depreciation upon ways and structures. Pursuant to the election given, petitioner continued to use the retirement method for ways and structures and consistently used that method at all times prior to and throughout 1934.

Las Vegas Land & Water Co., hereinafter sometimes called the land company, during the period here pertinent was a corporation organized and existing under the laws of Nevada. It was incorporated in 1905 and was a wholly owned subsidiary of petitioner.

In order to secure water for the operation of its railroad it was necessary for petitioner to acquire on July 2, 190,, a tract of land containing about 1,861 acres lying on both the east side and west side of its right of way. Three springs were located on the westernmost part of this tract. The tract embraced a very large area of land not needed for strictly railroad operating purposes, nor was the traffic at that time of sufficient volume to absorb all of the available water. That portion of the tract lying west of the railroad tracts was retained by petitioner mainly for the purpose of protecting the water supply, but part of it was also used for right of way or freight and passenger depots for a terminal yard, shop plant, storehouse, repair tracks, and the usual terminal facilities.

On May 8, 1905, petitioner conveyed that part of the tract lying east of its right of way, containing about 1,277 acres, to the land company, which was incorporated originally to establish the town site of Las Vegas, at which place petitioner had created a main division point or terminal on its railroad. The land company established the town site during 1905 and later made an addition thereto, using for these purposes much less than one-half of the land conveyed to it. The remainder was held in its original condition and, so far as it was used at all, was devoted to agricultural purposes. The spring water that was acquired by petitioner had been previously used beneficially on the tract for irrigation purposes many years prior to the railroad's advent into that country, and the water rights were acquired before there was any comprehensive water law in Nevada and were vested rights. At first the water was used there for irrigation purposes. In order to preserve its water rights in its springs it was necessary under state law that the water be used beneficially. Accordingly, until about 1921 petitioner sold the excess over its needs for railroad purposes to the land company, which as a public utility distributed and sold it to the inhabitants of Las Vegas under a certificate of public convenience and necessity issued by the Public Service Commission of Nevada.

Until about 1931 there was sufficient water flowing from the springs for all railroad and municipal purposes, irrigation purposes having dwindled. As the town of Las Vegas began to grow and as its area increased and the population moved outside the original town site into the adjacent subdivisions there began to be a shortage of water for municipal purposes. About 1934 petitioner drilled an artesian well adjacent to the springs and secured a flow of over 8 cubic feet per second. Petitioner appropriated 2.5 cubic feet per second for railroad and domestic uses and a certificate of appropriation was issued to it by the State of Nevada. This quantity of water was sufficient for the present and contemplated needs of petitioner and the appropriation needed no protection other than use of the water for railroad purposes. The balance of the flow was appropriated by the land company for either municipal or irrigation purposes other than railroad purposes.

At no time did petitioner have a franchise from the city of Las Vegas, Nevada, to operate or to install the facilities necessary to operate a water distribution system within the limits of that city, and at no time did petitioner have a certificate of convenience and necessity to operate such utilities within the city. There was no legal bar under state law or under petitioner's articles of incorporation to petitioner's obtaining such certificate and distributing water as a public utility.

A part of the land within the town site and addition was dedicated to the public by the land company for use as streets and ways, public schools, a court house, public parks, etc. The remainder was laid out in 2,053 lots. Prior to January 1, 1934, the land company built 64 dwellings on 64 of these lots. It sold 45 of the houses and lots to railroad employees and 2 to persons not connected with the railroad. It built a boarding house on 4 lots for the accomodation of 75 unmarried railroad employees. It sold 2,008 lots to buyers not identified by the evidence. On January 1, 1934, the land company owned 17 lots improved with dwellings which it rented to railroad employees and others, the boarding house, and 74 unimproved lots held for sale. In selling and renting its properties the land company made no concessions to railroad employees as such. Where credit was extended to an employee, payment was secured by provision for deductions from the employee's pay check.

In 1934 Las Vegas had a population of about 8,000, of whom 300 to 400 were railroad employees.

In 1934 the land company did not produce or sell electricity. Its water operations that year resulted in a profit of $24,711.85.

By three deeds dated September 24, 1924, July 22, 1925, and May 11, 1928, respectively, petitioner conveyed to land company 917,564 square feet of land adjacent to the terminal facilities of petitioner at Yermo, California. This property was acquired, on recommendations of W. H. Comstock, the general manager of petitioner, and of Walter R. Bracken, vice president and agent of the land company, and of E. E. Calvin, president of the land company, assented to by the executives of petitioner at Omaha and New York for the purpose of laying out a town site. The lots were to be sold preferentially to employees of petitioner for the purpose of encouraging and enabling all worthy and desirable employees to obtain permanent residence. Sales to others than employees who would build houses for rental to employees, as well as sales for public purposes in connection with supplying the wants of employees, were contemplated. None of the lots were to be sold for speculative purposes. It was hoped that this scheme would so improve conditions that petitioner would be able to obtain the best type of employees, with the result that there would be a material saving in cost due to labor turnover. By January 1, 1934, 106 lots had been sold to employees and others, and 86 remained unsold.

In 1922 petitioner determined to obtain a larger share of citrus fruit and nut shipments from packing companies in southern California. This required the construction of packing houses on the lines of petitioner and development of industrial properties on its lines. The land company commenced the acquisition or construction of ‘packing houses,‘ which it leased to packers. These packing houses were, with one exception, located outside of Los Angeles.

The leases in the first instance were negotiated by representatives of the operating department of petitioner and a representative of petitioner's traffic department. The financial responsibility of a prospective lessee and the potential traffic he might produce for petitioner were considered carefully, as was also the yield to the land company on its investment. If potential traffic was not considered satisfactory, negotiations were terminated. When these two representatives of petitioner recommended a lease jointly to their superiors the recommendation was forwarded to Omaha, and if assented to by petitioner's representatives it was transmitted to New York for the assent of the executive committee of petitioner there. This assent was expressed in the form of a resolution reading as follows:

Resolved, that this Company, as stockholder of Las Vegas Land and Water Company, hereby assents to the execution by that Company of the aforesaid new lease on terms recommended by President Gray.

After such assent was expressed by the executive committee the necessary documents were executed by officers of the land company and the execution of these documents was ratified by the board of directors of the land company.

In 1922 the land company also acquired in East Los Angeles extensive tracts of farm lands. Such lands had inadequate street access, no public utilities, and no development in the way of trackage. Through the efforts of one Strong, who in 1923 had been assigned to take charge of industrial properties of petitioner and also those of the land company, the city and county authorities were persuaded to construct highways to and through the properties and to install sanitary and storm sewers and to provide for electricity and gas. The land company paid for these improvements. Lead tracks from petitioner's railroad were also installed. The properties were held for sale rather than lease. In 1934 there were no leases of industrial properties. Sales of these industrial properties were negotiated in the same manner as the leases on packing houses, and the same considerations of financial responsibility of the purchaser, the potential traffic to petitioner, and the profit to be derived by the land company governed. There was a general policy with respect to the property of the land company of holding back the more attractive properties. Such a policy had been effective, and as of 1934 the best properties were still to be sold. By January 1, 1934, the land company had sold 21 of these tracts to industries.

Both the packing houses and industrial properties were in proximity to the lines of petitioner and susceptible to railroad service by petitioner. These properties could not be served by any other railroad.

Petitioner derived a substantial revenue from shipments to and from the packing houses and from industries built on the industrial tracts. For the years 1925 to 1934, inclusive, 17,884 carloads of citrus fruit originated in the citrus packing houses alone, on which the estimated Union Pacific revenue was $5,740,764. Shipments to and from industrial tracts were likewise substantial. No exact figures of industrial shipments for the period 1925 through 1934 are available. It is estimated that carload shipments to or from these industrial tracts to and from an eastern destination were in the neighborhood of 1,000 carloads a year, and there were approximately 1,100 carloads of such traffic locally. There were also substantial shipments from packing houses other than citrus fruit packing houses amounting to over 1,000 carloads a year for eastern destinations. Out of approximately 81 parcels of land company property, 36 had been sold and 21 leased during 1934. Of those disposed of 54 produced no, or substantially no, traffic. An aggregate of approximately 5,184 carloads of traffic in 1934 were from industries which had bought or leased land company property.

Between December 22 and December 31, 1934, petitioner, Short Line, Union Pacific, and the land company entered into a contract effective January 1, 1934. The agreement recited that the land company owned real estate chiefly in Los Angeles, California, adjacent to or in close proximity to the lines of petitioner, which it had acquired for the purpose of sale or lease to industry which would produce traffic over the lines of one or more of the Union Pacific System companies; that the land company was engaged in making sales and leases of such real estate but only when and as requested by officers of the Union Pacific System companies and upon explicit assent of petitioner; that sales or leases except in relatively unimportant instances were made only to such traffic-producing industries; that such real estate operations can be carried on by a separate company more advantageously than by any of the system companies; that sales or leases of real estate in small market were retarded by the policy of selling only to such traffic-producing industries; that the land company's income for this reason was insufficient to meet its expenses; that the real estate operations constitute the major part of the land company's business, but other activities are profitable; that petitioner, Short Line, and Union Pacific desired the land company to continue its operations in such manner that such real estate would be sold or leased only to industries which it was believed would produce traffic as above stated, and to that end were willing to reimburse the land company for any losses which it might sustain in the conduct of its business as a whole. The contract provided that petitioner, Short Line, and Union Pacific jointly and severally agreed to reimburse the land company for any net losses which the land company might incur in any calendar year, in consideration of which the land company agreed to pay over to petitioner, Short Line, and Union Pacific any net profits which might accrue to it in any calendar year and in further consideration of which the land company agreed to make no sales or leases of any real estate hereinbefore referred to except upon the express assent of petitioner. Petitioner, Short Line, and Union Pacific were to determine among themselves by agreement from time to time the percentages of such losses to be paid by each and the percentage of such profits that would be paid to each. The agreed proportions for the distribution of losses or profits for the year 1934 were, petitioner 40 percent, Short Line 20 percent, and Union Pacific 40 percent. These percentages were derived from an arbitrary estimate of the proportionate benefits to be realized by each of the respective railroads from traffic produced by the facilities owned and operated by the land company. Proportions determined upon the approximate mileage of the respective railroads were considered equitable. During the year 1934 the net loss referred to in the agreement incurred by the land company was $37,055.99, and Short Line paid 20 percent, or $7,528. It appears that the deficit of the land company was caused by the payment of taxes on vacant lands held by it for sale.

In its return for the calendar year 1934 the land company included in its gross income the $37,639.98 received by it from petitioner, Union Pacific, and Short Line. After including this sum the taxable net income shown was $187.15.

Utah Parks Co. (hereinafter called the parks company), during the period here pertinent, was a corporation organized and existing under the laws of the State of Utah. It was incorporated in 1923 and all of its stock was owned by petitioner.

In 1922 petitioner planned to build hotels and camps inside national parks and other territory in southern Utah and adjoining territory in Arizona north of the north rim of the Grand Canyon, to make such attractions accessible and available to the public, and to conduct a motor transportation service between Cedar City, Utah, and such hotels and camps. This plan could not have been carried out unless a line of railroad or other means of transportation from Lund, Utah, on the main line of petitioner to Cedar City, Utah, the gateway to the area, was available. During the year 1923 petitioner constructed such a line of rail from Lund to Cedar City, and in 1923 caused the parks company to be incorporated to conduct the planned operations other than the construction of the line of railroad and its operation.

The purpose of petitioner in developing the parks was to increase its revenue.

From January 1923, two months before the incorporation of the parks company, petitioner contemplated a separate corporation to operate the properties in the parks, though operation of such facilities by petitioner was also considered. Among the factors in favor of operation by a separate company was the fact that the operation of buses would be hazardous, and a well known railroad company would be subject to larger claims than a smaller local company in connection with personal injuries. It was thought that complaints common to the operation of hotels might embarrass a railroad company.

Rules and regulations promulgated January 16, 1928, pursuant to law, by the Secretary of the Interior made it necessary to obtain permission in writing from the Director of the National Park Service for anyone to reside permanently, engage in any business, or erect buildings in national parks.

In years prior to 1934, 13 licenses or permits had been issued to petitioner from the Forestry Service of the Department of Agriculture.

In a telegram dated May 24, 1923, to the president of the Union Pacific, petitioner's general solicitor reported:

Have interviewed Cammerer, Mather, Finney and Secretary Work. Mather very much opposed to contract in name of railroad; reason being it will accentuate attacks on Department based on claim that monopoly is being granted and that railroad will be interested only in tourists who travel by rail and will overlook those who use automobiles. Finney and the Secretary agree with him. In my judgment it will be mistake to attempt pressure on Mather at this time. * * *

The Messrs. Work, Mather, Cammerer, and Finney were, respectively, Secretary of the Interior, Director of National Parks, Assistant Director of National Parks, and Solicitor for the Department of the Interior.

In a letter dated May 24, 1923, one of petitioner's attorneys wrote:

* * * If the contract should be made in the name of the Utah Parks Company and the Department later on changed its mind and consented, the contract could be transferred to the railroad company.

The minutes of a meeting of petitioner's executive committee held August 21, 1923, state:

* * * owing to the unwillingness of the Interior Department to grant to a railroad company concessions in Zion National Park, it had been found necessary to secure such concessions in the name of the Utah Parks Company, which had been incorporated for that purpose, its stock being subscribed for by The Railroad Securities Company; * * *

The contract relating to the allocation of the parks company's losses for 1934, to which more extended reference will be hereinafter made recites:

* * * The Parks Company was incorporated for the purpose of conducting operations in furtherance of said project, for the reason that under regulations of the United States Government railroad companies are not allowed to own or operate facilities in national parks. * * *

There were advantages in operation by a separate company and petitioner did not make an issue of the matter. Petitioner had the corporate power to conduct the operations carried on by the parks company. Effective August 13, 1923, it amended its articles of incorporation to permit it to do this type of business.

The parks company, under contracts with the Interior Department (the dates of which appears after the names of the parks), operated in Zion National Park (June 9, 1923), in Grand Canyon National Park (October 13, 1927), and Bryce Canyon National Park (September 15, 1928), hotels, cabins, cottages, and camps for the accomm odation and entertainment of tourists, including the vending of newspapers, periodicals, souvenirs, photographic supplies, pictures, and other supplies or convenience for its patrons, a general merchandise store, and every service incident thereto, with such plants, animals and equipment and accomm odations as were proper and necessary and in such manner as the Secretary of the Interior deemed satisfactory. The hotel accomm odations were furnished in accordance with a tariff or schedule approved by the Secretary of the Interior. The prices to be charged were not to be in excess of those which would produce a reasonable profit. The parks company also operated buses and automobiles for the transportation as a common carrier for hire of passengers, baggage, express, freight, and mail to and through the parks and between its hotels and the railroad stations of petitioner at Cedar City and at Lund, and between intermediate points.

The agreement between the parks company and the Secretary of the Interior relating to Zion National Park, covering a ‘term of twenty (20) years from January 1, 1928,‘ contains a provision to the effect that:

No transfer or assignment of this contract or lease or any part thereof made pursuant thereto shall be valid or recognized by the party of the first part (the United States) unless such assignment is first approved in writing by the Secretary of the Interior.

The parks company offered no inducement to patrons of petitioner's railroad and charged them at the same rates as it charged the public generally.

Petitioner at all times prior to 1933 operated by railroad between Lund and Cedar City transportation facilities for passengers and baggage connecting with petitioner's through trains operating through Salt Lake City and Los Angeles, and prior to the depression it operated cars and through trains to Cedar City. The parks company, after 1933, operated a bus service between Lund and its hotels within the parks and between intermediate points for the transportation of passengers and baggage.

On September 1, 1923, a contract was entered into between petitioner and the parks company which recited that petitioner had previously adopted a project for the development of and making accessible the natural scenic attractions of southern Utah, including the construction and operation of a branch line of railroad from Lund to Cedar City; that part of the project, consisting of the construction and operation of a hotel, camps, and incidental facilities in Zion National Park and the operation of a motor bus line from Cedar City to and through the park had been covered in a contract between the parks company and the Interior Department; that the undertaking by the parks company would be a component part of petitioner's project; that the entire project would promote passage of traffic over petitioner's lines; that the portion of the project undertaken by the parks company could not be conducted at a profit justifying the necessary investment if considered separately from the increased railroad revenues accruing from the tourist traffic promoted by the project. It was agreed, inter alia:

That as between the parties hereto, but without in any respect affecting the relations of the Parks Company to the Department of the Interior of the United States or its status as an independent contracting party under the Zion Park contract, the Parks Company shall be deemed to be the agent of the (petitioner) * * *

and that: ‘ * * * as between the parties hereto, the Railroad Company shall be vested with an equitable title to all property.‘

It further provided that:

All operations of the Parks Company in respect of the matters covered by the Zion Park contract or other matters undertaken by the Parks Company with the assent of the Railroad Company shall be for the account of the Railroad Company * * *

The Parks Company shall in all respects faithfully perform the Zion Park contract, in complete accord with its letter and purpose, and in the performance of said contract and in all of its relations with the Department of the Interior under said contract shall act as an independent principal and without consulting the interests of (petitioner) * * *

Petitioner also agreed to furnish without interest all capital funds required by the parks company. Petitioner agreed to indemnify the parks company from any loss incurred in respect of its capital or property investment under the Zion National Park contract.

By agreement dated November 10, 1927, between petitioner and the parks company, the agreement of September 1, 1923, was supplemented to include the operations of the parks company under the concessions in the Grand Canyon National Park, and on October 11, 1928, it was further supplemented to include the operations of the parks company in Bryce Canyon.

On December 31, 1928, petitioner and the parks company entered into an agreement pursuant to which petitioner assigned, transferred, and conveyed to the parks company all property used by the parks company in its operations in the Zion, Grand Canyon, and Bryce Canyon Parks, equitable title to which had been held by petitioner under the agreement of September 1, 1923, as supplemented by agreements of September 10, 1927, and October 11, 1928, and petitioner agreed to assume and reimburse the parks company for any net loss incurred by the parks company in its operations as then conducted, in consideration of which the parks company agreed to pay to petitioner any net profit resulting to the parks company from its operations.

On December 13, 1934, petitioner and the parks company entered into an agreement under which petitioner's obligation to reimburse the parks company for losses and the parks company's agreement to pay over net profits to petitioner were terminated as of December 31, 1933. At the same time petitioner, the parks company, Union Pacific, and Short Line entered into a contract, effective January 1, 1934, under which petitioner, Union Pacific, and Short Line agreed to assume and reimburse the parks company for any net losses which the parks company might incur in any year, and the parks company agreed to pay over to petitioner, Union Pacific, and Short Line any net profits which might accrue to it in any calendar year. The agreed proportions for distribution of losses and profits in effect for 1934 were, petitioner 50 percent, Union Pacific 40 percent, and Short Line 10 percent. These percentages were derived from an estimate of proportionate benefits to be realized by each of the respective railroads from traffic produced by the facilities owned and operated by the parks company.

Part of the bus operations conducted by the parks company was a bus service from the north rim of the Grand Canyon to Vermilion Cliffs Lodge at Lee's Ferry Bridge, which was wholly intrastate in the State of Arizona, and the parks company obtained a certificate of convenience and necessity for such operations from the Arizona Public Service Commission. In 1929, pursuant to Arizona statute, the Arizona commission refused to issue such a certificate to a foreign corporation, so the parks company caused a new corporation, hereinafter called the Arizona company, to be incorporated under the laws of the state. It applied for and received certificates of convenience and necessity from the Arizona commission.

The parks company and the Arizona company entered into a contract dated December 31, 1930, whereby the parks company agreed to operate in the name and on behalf of the Arizona company, but with employees and equipment of the parks company, the intrastate bus service for which the Arizona company held a certificate of public convenience and necessity. The operations were to be conducted at the sole cost of the parks company, which was to retain as its own all revenues derived from the transportation. In 1934 no buses were operated under this contract and the Arizona company had a net loss of $45.64, which deficit was paid by the parks company.

After the national parks were established there was substantial tourist traffic over petitioner's lines to and from the parks. For the year 1929 there were over 5,000 passengers who entered the southern Utah parks via rail-bus, and in 1932 there were over 1,000. The average system revenue per passenger from such travel is estimated to be $40. During 1933 there were 47,485 visitors by automobile and in 1934 there were 67,226.

Advertising of the Utah parks by petitioner commenced in 1924 and was carried on each year thereafter by means of newspaper and magazine advertising, booklets, leaflets, and other miscellaneous methods. This advertising emphasized the fact that these parks were reached by the Union Pacific System. The advertising was paid for by Union Pacific as part of the system expense and ranged from $120,000 in 1928 to a low of approximately $2,400 in the depression year 1933.

During the year 1934 the net loss referred to in the agreement between the the parks company, Union Pacific, and Short Line was $178,053.13, of which petitioner paid 50 percent, or $89,026.57; Union Pacific paid 40 percent, or $71,221.25, and Short Line paid 10 percent, or $17,805.31.

In its return for the calendar year 1934 the parks company included in its gross income the $178,053.13 received by it from petitioner, Union Pacific and Short Line. After including this item there was shown a deficit of $95 in taxable net income.

The businesses conducted by the subsidiaries, respectively, were separate and distinct and were not mere branches or divisions of the business of the railroad company.

The railroad company could not at any time have regularly carried on the business conducted by the parks company without a franchise from the National Park Service of the Department of the Interior.

During all the times herein mentioned the officers and directors of the land company and the parks company were, with the exception of statutory representatives, individuals who were also officers of petitioner or Union Pacific.

In its declared value excess profits tax return for 1934 petitioner claimed as deductions the payments made by it to the land company and the parks company pursuant to the agreements, and respondent in the notice of deficiency disallowed both.

OPINION.

OPPER, Judge:

The first issue relates to a phase of petitioner's depreciation accounting. The system employed by it is sometimes referred to as the retirement method. Both parties apparently recognize that by this means a taxpayer, particularly a railroad company such as petitioner, can reflect its loss from depreciation with adequate accuracy. The narrow question presented is whether when in 1934, the tax year before us, petitioner retired and wrote off certain components of its ways and structures which had been acquired prior to 1913, it should have reduced the ledger cost, maintained on its books apparently from the date of acquisition, to compensate for depreciation actually sustained prior to March 1, 1913.

Exhaustion and wear and tear is a physical fact. Its existence and extent are at least theoretically measurable. Various accounting practices designed to reflect its influence upon earnings and investment differ widely in detail. But no accounting system of itself creates exhaustion, or eliminates it. We are consequently unable to agree that, because the retirement system in use by petitioner assumes a constant level of repair and efficiency for the railroad property as a whole, it could undo the physical deterioration to which specific properties were subject.

Respondent's computation of the depreciation suffered prior to 1913 by the properties retired in 1934 was apparently based upon an arithmetical calculation on the assumption of straight line depreciation over the useful life of the property. This approach very possibly bears no true relation to the actual deterioration sustained before 1913 by petitioner's property, and offers a less than satisfactory measure for application of the statutory language referring to ‘exhaustion, wear and tear * * * to the extent sustained. ‘ But there is no dispute between the parties as to the depreciation of the specific assets in question or as to its amount. Petitioner's counsel stated at the hearing its intention ‘to concede that depreciation was sustained in the amount in question, $88,000.‘ The fact that the railroad as a single property may have maintained an undiminished value would not dispose of the existence of depreciation in particular instances. Cf. Central Railroad of New Jersey, 35 B.T.A. 501,507.

It does not follow, however, that any adjustment of petitioner's ledger cost to reflect that item is required. The statute, it is true, calls for an adjustment of basis for depreciation ‘to the extent sustained.‘ But it also limits the command to what is ‘proper.‘ Under the retirement system of depreciation accounting, expenses of maintenance, including restorations and renewals, even though under other systems they might require capitalization (see Bureau of Internal Revenue Bulletin F (1942), p. 7), are deducted as operating costs. These charges, coupled with the deduction of the cost of the item upon its retirement, are considered to be the rough equivalent of other methods of recovering cost through deductions for depreciation. Central Railroad of New Jersey, supra. It is thus evident that any specific physical property might be the vehicle for expenditures of restoration and renewal which in the case of a growing railroad could well equal or even exceed the depreciation occurring during the same period.

Revenue Act of 1934:‘SEC. 114. BASIS FOR DEPRECIATION AND DEPLETION.‘(a) BASIS FOR DEPRECIATION.— The basis upon which exhaustion, wear and tear, and obsolescence are to be allowed in respect of any property shall be the adjusted basis provided in section 113(b) for the purpose of determining the gain upon the sale or other deposition of such property.‘‘SEC. 113. ADJUSTED BASIS FOR DETERMINING GAIN OR LOSS.‘(b) ADJUSTED BASIS.— The adjusted basis for determining the gain or loss from the sale or other disposition of property, whenever acquired, shall be the basis determined under subsection (a), adjusted as hereinafter provided.‘(1) GENERAL RULE.— Proper adjustment in respect of the property shall in all cases be made—‘(A) for expenditures, receipts, losses, or other items, properly chargeable to capital account, including taxes and other carrying charges on unimproved and unproductive real property, but no such adjustment shall be made for taxes or other carrying charges for which deductions have been taken by the taxpayer in determining net income for the taxable year or prior taxable years;‘(C) in respect of any period prior to March 1, 1913, for exhaustion, wear and tear, obsolescence, amortization, and depletion, to the extent sustained;‘

The obvious purpose of the provisions of section 113(b) in so far as they relate to March 1, 1913, adjustments, was to arrive at the amount of investment incorporated in the property on that date. See Ways and Means Committee Report, H.R. 1, 69th Cong., 1st sess., p. 5; 1939-1 C.B. (Part 2), p. 318; cf. United States v. Ludey, 274 U.S. 295. Thus, in addition to the requirement of depreciation adjustment, there is the further reference dealing with property ‘whenever acquired‘ to ‘expenditures, receipts, losses or other items properly chargeable to capital account.‘ No fair approximation of petitioner's investment in the properties in question or in any other properties retired or to be retired is feasible without the details of both expenditure and depreciation. But one of the purposes of the retirement system was to avoid the ascertainment and preservation of innumerable, comparatively small bookkeeping items. See Chicago & North Western Railway Co. v. Commissioner (C.C.A., 7th Cir.), 114 Fed.(2d) 882, 886, affirming 39 B.T.A. 661; certiorari denied, 312 U.S. 692. Respondent recognizes that ‘the books frequently do not disclose in respect of the asset retired that any restoration, renewals, etc. have been made— much less the time or the cost of making them.‘

See footnote 1, supra.

But unless the retirement system is capable of producing a figure which will fairly reflect the March 1, 1913, investment as to both positive and negative figures, we can not regard it as proper to make an adjustment in one direction while recognizing the impossibility of others of a compensating character. It seems to us to follow that it would be inconsistent with the retirement system to call for an adjustment for pre-1913 depreciation and consequently that under the circumstances here present that adjustment is not ‘proper‘ and accordingly need not be made.

The remaining question concerns deductions claimed by petitioner on account of the loss sustained by two of its subsidiaries which it made good. The details of the purpose and operation of the subsidiaries and of the arrangements among petitioner, its affiliates, and the subsidiaries are set forth in detail in our findings of fact and will not be repeated here.

Normally corporations are separate juristic persons and are to be so treated for tax purposes. Burnet v. Commonwealth Improvement Co., 287 U.S. 415. There are exceptions, particularly where the subsidiary is so much a part of the parent in its operations that it amounts to no more than a mere department or agency. Southern Pacific Co. v. Lowe, 247 U.S. 330; North Jersey Title insurance Co. v. Commissioner (C.C.A., 3d Cir.), 84 Fed.(2d) 898; Munson Steamship Lines v. Commissioner (C.C.A., 2d Cir.), 77 Fed.(2d) 849; cf. Higgins v. Smith, 308 U.S. 473. But usually there is a purpose in the creation of a separate legal entity and it is illogical and unrealistic to recognize the benefits flowing from separation of the corporate individuals and in the same breath to permit the parent to absorb the loss of the subsidiary for tax purposes as though the two were a single unit. Mississippi River & Bonne Terre Railway, 39 B.T.A. 995; cf. United States Fidelity & Guaranty Co., 40 B.T.A. 101; Valuation Service Co., 41 B.T.A. 811.

The first question in its present aspect is whether this situation is changed by the creation of a formal contract whereby the parent commits itself to defray the loss of its affiliate. It is clear, however, that the mere existence of a contract is not sufficient to convert such losses into ordinary and necessary business expense of the parent. The situation must be more closely examined to see whether in fact the expenses are business expenses and whether they are ordinary and necessary/ Interstate transit Lines v. Commissioner, 319 U.S. 590; U.S. Industrial Alcohol Co. v. Helvering (C.C.A., 2d Cir.), 137 Fed.(2d) 511, 518. For separate reasons it seems to us that the two deductions claimed here fail to qualify under these principles.

The land company was organized to deal in real property and related items, such as water and electricity. It may be freely granted that some benefit accrued to petitioner's business from these operations. But it by no means follows that the payment of the land company's losses for 1934 was a necessity for the bestowal of these advantages. Petitioner concedes that the land company's operations were conducted with a view to the securing of profits, and there is no demonstration that if a deficit was sustained in 1934 that was necessarily a permanent condition. Indeed, profits were apparently contemplated, since the same contract called for payment by the subsidiary to petitioner and its affiliates of the profits resulting in favorable years. The mere fact that petitioner undertook to bear this loss is hence no demonstration that either the contract itself or the payment under it was necessary, even though it might be persuasive if the parties had been dealing at arm's length. See U.S. Industrial Alcohol Co. v. Helvering, supra. It does not in fact appear that in spite of the current operating deficit the land company's financial condition was such that petitioner's action was necessary in order to secure the continued operations of the subsidiary.

Nor do any of the other attendant circumstances point to the necessity of the payment as a business expense. It was not until virtually the last day of the year that by the contract upon which petitioner relies it committed itself to undertake the designated reimbursement. Until then there had been no legally binding obligation upon it, although such benefits as it sought had already been secured. It was thus in a position to wait until the results of the year's operations were known or could reasonably be estimated both as to itself and as to the subsidiary. Its action then had more of the aspect of a voluntary application to the two companies of what amounted to filing a consolidated return than to an unavoidable operating payment. The consolidated return was a privilege which in that very year was withdrawn from companies of the nature of petitioner and its affiliate; and of which the legislative purpose was precisely to eliminate permission for ‘the loss of one corporation to reduce the net income and tax of another.‘ See G.U.R. Co., 41 B.T.A. 223, 227; affd. (C.C.A., 7th. Cir.), 117 Fed.(2d) 187. By such a practice as that instituted by petitioner, not only could the result of consolidated returns be obtained in the years when they would prove beneficial either to the parent or the subsidiary, but the requirement of consistency would be eliminated, since a contract made in December of one year might have been canceled by mutual consent at the end of the next. At any rate, we do not regard such considerations as indicating the necessity for the contract. It is thus not so much on the ground that the action in question lacked a business purpose, see Gregory v. Helvering, 293 U.S. 465, as that the business necessity for the expenditure remains unproven on this record that we think the requirements of section 23(a) are lacking.

Since the subsidiary was committed to pay its profits to petitioner, there is no assurance that attempts to deduct these gains as a business expense of the subsidiary might not arise in years which were profitable for it but not profitable for the parent.

See e.g., Regulations 75, art. 11(a).

There is a different reason for denying the claim as to the losses of the parks company. Its purpose was to operate concessions in the national parks. It appears that when the concessions were granted the Department of the Interior was unwilling to confer them upon a railroad company such as petitioner. This was recognized by petitioner as a reason for the organization of the parks company and the application by it for the concessions. It is true that the record remains obscure as to whether in the year before us petitioner, had it changed the method of operation, could have applied for and secured the concessions in its own name, but there is nothing to indicate an affirmative answer, and any failure of proof in this respect is a disadvantage from which it and not the respondent must suffer. Treating the operations of the parks company then, as we must, as transactions which would have been illegal if conducted by petitioner itself, everything announced on this subject in Interstate Transit Lines, supra, is equally applicable here. The loss in question can not be regarded as a part of the business of petitioner and hence must be disallowed as business expense.

Charged by law to ‘make and publish such rules and regulations as he (the Secretary of the Interior) may deem necessary or proper for the use and management of the parks * * * . He may also grant privileges, leases, and permits for the use of land for the accomodation of visitors in the various parks * * * .‘ Public No. 235, 64th Cong., 1st sess., approved Aug. 25, 1916, 39 Stat.L. 535.

Reviewed by the Court.

Decision will be entered under Rule 50.