FRIBOURG NAV. CO. v. COMMISSIONER
Legal provision: Internal Revenue Code
Argument of James B. Lewis
Chief Justice Earl Warren: Number 23, Fribourg Navigation Company Incorporated Petitioner versus Commissioner of Internal Revenue.
Mr. James B. Lewis: Mr. Chief Justice, may it please the Court?
This case, here on petition for writ of certiorari to the Second Circuit presents a simple, but fundamental question of how depreciation should be computed for income tax purposes.
Ever since 1913, the income tax statute has granted us a deduction, a reasonable allowance for the exhaustion wear and tear of property.
This Court has asked in this case to interpret that 42-year-old statutory language on this issue for the first time.
The facts are undisputed and maybe quickly stated.
The taxpayer purchased in December of 1955, one of the old World War II Liberty ships for $469,000 and proceeded to use that ship in its shipping business as a tramp steamer.
Before making the purchase, the Commissioner came down the -- the taxpayer came down to Washington, and asked the Commissioner for a ruling on depreciation and received such a ruling.
The Commissioner, having experience in this field, rule that this Liberty ship was to be depreciated over a three-year useful life that the amount to be depreciated was the $469,000 cost plus a salvage value based on scrap of $5 a dead-weight ton or $54,000.
And that the depreciable amount $415,000 was to be written off over the three-year useful life under the straight-line basis, one-third each year.
The taxpayer followed the ruling letter meticulously.
A year later, something happen that no one could have expected, the Suez Canal crisis erupted.
The canal was blocked for about six months.
And when it reopened, it reopened under Egyptian management that many people then had limited confidence in.
During this brief crisis, the prices of all kinds of ships even Liberty ships rose spectacularly because the necessity of going around Africa caused a brief, but severe, shipping crisis.
During 1957, all of 1957 except the last eight days, the taxpayer operated its ship, produced a gross profit from that operation of almost $300,000 and filed an income tax return on which disclosed that profit and deducted there from its expenses including the depreciation of about $135,000 that had been authorized in the ruling letter.
The taxpayer had a substantial net profit for 1957 roughly $140,000 from the operation of this and a less important ship.
Having received and unsolicited and attractive offer from a competitor during the Suez crisis, the taxpayer sold the Liberty ship in December of 1957 for the price of about $695,000.
Justice Hugo L. Black: How long did he own it?
Mr. James B. Lewis: For two years.
The dispute here arises from the Commissioner's total disallowance of depreciation for the ship for 1957.
The Commissioner asserts that the depreciation, which he concedes, to have been correctly established by the ruling letter was nevertheless the automatically disallowed for one reason only because the sale of the ship produced a profit.
Justice Potter Stewart: The rule for which he contends limited to the -- that year, that the year in which the sale was made.
Mr. James B. Lewis: Yes.
His argument on trade fair is that he here is that he will not touch and should not touch the depreciation allowed for the years prior to the year of sale.
Now, although this was the first time that this narrow but significant issue has been presented to this Court, the Court is not being asked to write on a clean slate.
Year after years since 1913, hundreds and probably thousands of taxpayers every year have sold some sort of depreciable property.
They have reported their gain or loss on the sale.
They have taken their depreciation for the year in which the sale occurred.
Their returns have been subject to audit and their returns have been audited.
And one has only to turn to the precedents to find out what the practice was and it was uniform or as uniformed as a practice that affects thousands of taxpayers every year can be.
Depreciation was regularly allowed for the year of sale regardless of whether the sale was a gain or a loss.
And we have cited in our brief to say -- well, a precedent, that reflects this fairly established administrative policy.
We have cited five early-published rulings.
More than 35 Court cases, five of which reached this Court and all of which the record shows without dispute the amount of depreciation taken for the year of sale.
Chief Justice Earl Warren: We'll recess now.
Mr. James B. Lewis: Thank you, Mr. Chief Justice.
I was saying that 35 or 40 Court decisions discussed in our two briefs reflect clearly the consistent allowance of depreciation for the year of sale of an asset at a profit.
Five of those cases reached this Court obliquely because generally a taxpayer will accept an allowance that the Commissioner has made instead of rejecting it.
So there is not an abundance of direct of adjudication on this issue prior to the last two or three years.
But the case is nevertheless reflected the consistent administrative policy.
This Court had such a case in 1921.
It had such a case in 1927, the Ludey case.
It had such a case in 1947, the Beulah Crane against Commissioner in which the Commissioner allowed Mrs. Crane's $3200 of year of sale depreciation on her building.
And this Court approved the Commissioner's computation of profit on sale by subtraction of that year of sale depreciation.
The Court had a group of such cases in 1960 and the Massey, Evans, and Hertz decisions in which the Commissioner allowed depreciation in the year of sale of automobiles at a profit.
Nevertheless, adjudication did arise, first, because a taxpayer cannot always use his depreciation deduction.
If he has an access of other deductions, he may prefer not to take his depreciation and to keep the basis of his property high, so as to reduce the capital gain that he otherwise has to report at the 25% rate.
This occurred to Herbert Simons.
And in 1930, in a Board of Tax Appeals decision, the Commissioner argued, “Mr. Simons, you must take your year of sale depreciation even though you cannot use it because otherwise, the system of allocating part of your cost of the asset to the part used up during its life, the system will be destroyed.
And we will not have either a correct reflection of depreciation or a correct reflection of gain on sale.”
And the Board of Tax Appeals says, “The Commissioner is absolutely right”.
This is what we have always held and this is what the courts have always held.
Throughout this long history and I'm talking now about 1913 to 1960, 47 years, there are two isolated cases of taxpayer contests of disallowances of year of depreciation by the Commissioner.
Now of course with a widely separated administration, this can happen now and then.
But on an issue involved in thousands of returns annually, we find two contests in 47 years.
Both of these cases resulted in clear holdings by the Tax Court that the depreciation was allowable.
In 1927 decision, Duncan-Homer and the 1947 decision Weir Long Leaf, both cases depreciation was clearly allowable for the year of profitable sale.
The Commissioner promptly acquiesced in the Weir case in 1948, and that equity essence was outstanding until the middle of 1962 when this case was already in the Courts.Congress in 1950 included in its committee report on the 1950 Revenue Act, a clear example of the taking of depreciation on an asset for the year of its profitable sale and a reporting of capital gain on the sale of that asset.
The Commissioner incorporated this committee report into the -- or the Treasury, incorporated it into the Treasury regulations and it was there from 1951, republished in 1953, again republished in 1957, and it stayed there until June of this year when the Commissioner decided it was too embarrassing and withdrew it.
The commercial accounting practice is exactly to the same effect as we've pointed out clearly in our briefs, clearly supports the tax practice.
And here, there is not an scintilla of reason for creating any divergences between commercial accounting and tax accounting for as this Court said and its latest depreciation decision, the Massey Case in 1960, the purpose of the commercial accounting and tax accounting systems here is harmonious.
They have the common function of achieving a proper reflection of net income.
Now during the period, that all of precedent accumulated 1913 to 1960, Congress re-enacted the depreciation provision, 12 times.
Repeatedly, Congress addressed itself in these 12 Revenue Acts and Codes to the problem of how depreciation on business asset and capital gain or loss on its disposition should work.
Again and again, Congress changed the treatment of gain or loss in 1921, '32, '38, '42, '47, '50, '51, '54, '62 and '64.
Again and again, focusing on the problem we have here, but again and again, in each of the 12 enactments and each of it's addresses to the problem, it left the depreciation provision that the Commissioner had always interpreted as allowing year of sale depreciation totally unchanged, the basic depreciation words today, except for the inclusion of the word obsolescence, are exactly what they were in the Revenue Act of 1913.
Suddenly, so as far as I can determine, sometime in 1960, the Commissioner privately determine that he would like to wipe the slate clean.
He didn't tell us this until 1962.
In June of that year, he published a Revenue Ruling that stated that now he did not want to allow depreciation for the year of profitable sale.
But since our case was docketed in the Tax Court late in 1960 and from such other evidence as I can find, 1960 or about the middle of 1960 was the time of the change.
Now, when this change occurred in 1960, there were no cases in the Courts involving this issue.
Now there are more than 300.
The Commissioner tries in his brief to say that this is an old policies following, and not a new policy.
But I think it's enough to tell you that there were no cases in 1960 and there are over 300 now.
This speaks for itself.
The Commissioner has only one excuse for this extraordinary course of conduct.
He says that over the first 47 years of the modern income tax, he didn't really focus on the issue.
He is --
Chief Justice Earl Warren: He really what?
Mr. James B. Lewis: He did not focus on the issue for the first 47 years.
He is dissatisfied, Mr. Chief Justice, with the quality of his eyesight for 47 years.
Now he says in 1960's, “eyes cleared”, and we have three replies to that.
First, you cannot read the authorities we have cited without being convinced that the focus was there.
We have quoted in our briefs portions of most penetrating analysis from these cases.
This Court's 1927 decision in Ludey contains the classic statement of the purpose of depreciation.
The Tax Courts early cases are equally penetrating.
The Commissioner's published rulings not only state that depreciation is allowable in the year of sale, they tell us why.
Secondly, the Commissioner cannot excuse 47 years of administrative practice, published rulings, court decisions, congressional re-enactment, committee reports, regulations, and equity essences in court decisions on the ground that his eyesight wasn't good.
He cannot just wave the magic wand of shortsightedness and dismiss what otherwise obviously has produced a rule of law that he can no longer change.
But our third answer is the most important.
And that is that his ability to focus did not improve in 1960, unfortunately, it declined.
His new position will not stand up on their analysis.
His position for 47 years stands up handily.
What he is now attempting to do is to scrap the basic function of depreciation which is the allocation of the original cost of an asset in a reasonable manner over the elements of income or loss that it will produce.
You've got to fragment its cost just as though you were buying a land and building, affixed non-depreciable asset and the depreciable asset or as though you were buying land and supporting standing timber again on the basis of the facts existing at the time of purchase, you've got to determine how many of the dollars you laid out must be considered the cost of the land, and how many the cost of the timber.
Similarly, this taxpayer when it bought the ship but two assets.
It bought an old Liberty ship that was going to be good for three years as a tramp steamer and it bought the right to receive the -- whatever the scrap iron would bring when the ship was scrapped at the end of the three years.
And just as you have to divide the original cost on some reasonable basis between the building and the land or the timber and the land, so it had to be divided here between the depreciable asset, the use of the ship as a tramp steamer and the non-depreciable asset, the use of the ship for scrap.
This is the ruling there, so we have no argument here about the correctness of the original determinations of salvage value and the balance of cost that's depreciable over the useful life because the ruling fixed that and the Commissioner does not repudiate the ruling.
We do not have the problem that was presented in Massey, the Massey and Hertz cases here in which the taxpayers have taken -- had made bad estimates, but we have approved estimates.
The Commissioner's says however that the estimates are merely provisional that the minute you determine what the actual period of holding is and what the actual sales price is, then you must abandon the provisional estimates.
You must abandon the temporary estimates because now you have the truth.
Now, you know how long the asset was used and what it was sold for, and these automatically supplant the determinations made at the time of purchase.
Our answer to this is that the ship that was sold in December of 1957 is not the same ship that was bought in December of 1955, nor indeed was the same ship that existed on January 1 of 1957.
In 1927, Justice Brandeis said in the Ludey case when the plant has disposed off after years of use, the thing then sold is not the whole thing originally acquired.
Therefore, you cannot match the cost of what was acquired a greater -- the cost of a greater asset against the sales price of a different asset, a lesser asset that it is sold later.
The Commissioner disregards that.
He wants to match the cost of the greater asset that existed on January 1, 1957 against the sale price received for the lesser asset in December of 1957.
And since the sale price received for the lesser asset, absorbs the cost of the greater asset, this is well during inflationary periods, he says the asset used up during the year costs nothing.
This is nonsense.
Obviously, the taxpayer did not get that the 1957 use of its ship for nothing.
Unknown Speaker: 370.
Mr. James B. Lewis: The clear reputation of the Commissioners' argument is his unwillingness to extend his principles to sales at a loss.
We have 326,000 of un-recovered cost on January 1, 1957, suppose too as it not happen and that the ship had been sold for $50,000.
He would be unwilling to allow increased depreciation for the year of sale.
He takes an approach of ‘heads, I win - tails, you lose'.
His approach however cannot be sustained.
Obviously, if the original determination of useful life and salvage value are purely provisional that they must yield to the facts as soon as the facts are known.
This is just as true for a sale at a loss as it is for a sale of a gain, and therefore, he cannot hold the line against the loss situation.
Now, what happened is this.
In 1962 and 1964, Congress cured his problem as to sales that he gained completely as to personal property, and in very substantial part as to real property by providing that upon the sale, the depreciation taken not only in the year of sale, but all during the life of the property must first be applied against the gain and recaptured as ordinary income, and only the balance of profit, if any, can be capital gain.
As I say, this is wholly true for personalty and partly true for realty.
The loss situation however remains open for exploitation and that there is no answer for the Commissioner to say that sales at a loss are ordinarily ordinary losses because very, very frequently they are not.
Often they are capital losses from one of two reasons.
They may have to be matched against gain on the sale of other types of assets, for example, a vacant land or the asset being sold may not be a business asset but an asset that I simply hold for the production of income, although I'm a lawyer, I may have a house that I am renting.
And there, I have to take a capital loss, just as the Commissioner contended recently that the owner of a resource had to take and contended successfully.
Thirdly, lots of losses cannot be taken at all.
If I trade-in my old business car on a new business car, I am denied any loss at all, it's nonrecognized.
And the Code has a long list, 15 or 20 nonrecognition provisions that we could examine in this connection and apply to what we have here.
Now, if the Commissioner is right, why has Congress denied recognition of losses for depreciable property?
And why has Congress provided that losses on sale of depreciable property under various circumstances shall be capital losses?
Because there are no such losses, the Commissioner now contends.
If the original estimates must yield to the actual sales price, losses from sales of depreciable property are wiped out, this great complex of Code provisions become meaningless and Congress is struggled with the loss problem in the 1938 Act, and then the 1942 Act, and then 1962, and then 1964, puts legislation in a vacuum, legislation on a non-existent problem if we believe what the Commissioner now says.
I will close by reading two sentences from the Commissioner's brief before this Court in the Massey case in 1960.
If, as the Commissioner contends, the depreciation deduction must be based upon a rate determined by the period during which the asset can reasonably be expected to be used in the taxpayer's business, and their reasonable estimate of salvage value at the end of that period, there will be no conversion of ordinary income into a capital gain.
Ordinary and predictable salvage value, determined as of the time that sale of the asset is contemplated will impose a realistic ceiling upon depreciation claims.
This court read the brief.
It decided its Massey decision on the basis of that brief.
The basis of that decision is what the Commissioner now asks this Court to overthrow.
Chief Justice Earl Warren: Mr. Levin?
Argument of Jack S. Levin
Mr. Jack S. Levin: Mr. Chief Justice, may I please the Court.
Well, I would like very much to spend the majority of my argument, as Mr. Lewis has not, on the merits of this case.
I recognized that although I have in my brief dealt at length with his re-enactment argument, I should also discuss it here.
Let me first state, as I see it, the issue on the merits.
And then, deal specifically with his re-enactment argument which does not go to the merits of the Commissioner's position, but whether Congress has precluded the Commissioner from taking his position.
In 1955, the petitioner purchased a ship for $470,000.
In December 1957, it sold that ship for approximately $700,000.
That is for $230,000 more than it originally paid for the ship.
Now the question on the merits for this Court is whether that the petitioner is entitled to take $135,000 deduction for depreciation in 1957.
That is the year in which it had already sold the ship for more than it originally he paid for it.
The Government's position in short is that since at the end of 1957, petitioner knew that the ship, that the use of the ship, had not cost at anything.
It was not entitled to take a depreciation deduction for that year.
We believe that petitioner should not be able to intentionally distort its income by deducting a $135,000 cost which it knows it will never incur.
I think that the difference between the petitioner's view and ours goes to the essence of the depreciation deduction.
We believe that the depreciation deduction is there like all the other deductions in the Code in order to permit the taxpayer to deduct against his income, the costs of earning the income.
And that is it not entitled, the petitioner like any other taxpayer, is not entitled to deduct the cost which it will not incur.
Of course, the depreciation deduction computed as it frequently is before the events must take into account estimates as to future events.
However, once those future events have occurred and the actual facts are known, we contend that thereafter, and only thereafter, the petitioner is required to take cognizance of reality and not to ignore it.
The regulations, which we believe are clearly authorized by the Code provision being interpreted and which the petitioner has not challenge, state specifically that the reasonableness of each year's allowance for depreciation shall be judged in terms of the conditions known to exist at the end of that year.
In other words, when you seek to compute your depreciation deduction in December of a given year, the last day of the year, you will judge the reasonableness of that deduction in light of the facts that are known.
Now, I will diverge for a moment from the argument on the merits in order to answer the re-enactment argument.
Justice Abe Fortas: Mr. Levin, just before you do that, as I understood most of the laws, his point is that the ship brought the less at the end of 1957 than it would have brought in the sale at the beginning of 1957, which to a layman sounds reasonably sensible, perhaps it isn't.
Mr. Jack S. Levin: Well, Your Honor --
Justice Abe Fortas: If that is so, if that is so and you'll tell me if it is not; if that is so, how do you reconcile -- how do you explain your statement that the use of the (Inaudible) 1957 cost the petitioner nothing?
Mr. Jack S. Levin: I will not take issue with the fact.
I will concede the fact that Your Honor states, Mr. Justice Fortas, what I do say is that the Code does not give a person a deduction for physical wear and tear but only for money expended.
In other words, if petitioner had purchased a machine worth $10,000 at the time when the market for such machinery was very depressed, so that the true value of the machine was much more.
Petitioner expected to use that machine for let's say two years.
And then petitioner reasonably expected to be able to sell that machine for $10,000, just exactly what it did pay for.
Justice Abe Fortas: But that's not this case, is it?
Mr. Jack S. Levin: Well, let me take that case first.
It is conceded, I believe by petitioner and by all concerned, that that man would not be able to take any deduction on the machine.
Even if, at the beginning of the second year of use, he could have sold the machine for $20,000, but that because he held it until the end of the year, he was able to sell it for only $10,000.
In other words, if an item doesn't costs a taxpayer anything an out of pocket money, he is not entitled to a deduction.
I think perhaps the clearest example is the taxpayer who operates his own business.
And he works hard from morning until night six days a week and he realizes that if had to hire somebody to come in there and operate that business, it would cost him $10,000 a year to pay the man.
Justice Abe Fortas: Perhaps, I know --
Mr. Jack S. Levin: If he doesn't hire anyone --
Justice Abe Fortas: Perhaps, I know --
Mr. Jack S. Levin: -- he is not entitled to a deduction.
Justice Abe Fortas: Perhaps, I'm mistaken Mr. Levin, but the amount that this taxpayer were to depreciate, it was the amount that he actually paid for the ship, isn't that right?
Mr. Jack S. Levin: Well, Your Honor, I don't think that the -- in deduction for depreciation was intended to permit a man to deduct the entire amount he originally pays for an asset, but only his net cost.
Justice Abe Fortas: Oh, I'm sorry.
I should have said based on the amount that it paid for originally.
Mr. Jack S. Levin: Yes, of course --
Justice Abe Fortas: That is --
Mr. Jack S. Levin: -- it was based on original cost
Justice Abe Fortas: Yes.
Mr. Jack S. Levin: However, at the time the taxpayer petitioner here sought to take that deduction, it knew that it was not going to incur that cost.
Now, the setup of the regulations which I believed interpret the Code --
Justice Abe Fortas: Excuse me, and this will be my last question for you.
Mr. Jack S. Levin: I'm happy to have your questions, Your Honor.
Justice Abe Fortas: But, your ship -- what do mean by, during when I -- what seems to me to be shifting back and forth between two price figures or cost figures are the latest cost figures, I want to be sure that I'm following you, this taxpayer has taken its original cost as the basis for depreciation.
Mr. Jack S. Levin: That's right.
Justice Abe Fortas: Isn't that right?
Now, that cost figure did not change?
Mr. Jack S. Levin: That's right.
Justice Abe Fortas: -- not changed the market so that the taxpayer at the -- sometime in 1957 was able to realize the problem.
Now, what bothers me is that I don't see the relationship between that figure and the initial figure which was a basis for the depreciation, if as I gather is not contested here, the original figure was a bona fide figure in this.
Mr. Jack S. Levin: Yes, Your Honor, it was bona fide.
And in fact, that I might mention that, as Mr. Lewis pointed out, there was a letter ruling at the beginning.
In other words, the taxpayer came in and he said to the Internal Revenue Service.
“I bought a ship and I paid $470,000.
I think it's going to -- I think I'm going to use the ship for three years.
And at the end of that period, I believe I will be able to sell it for scrap steel for $50,000.
I think, it's going to cost me $420,000 for the ship.
And I would like to write that off over the straight-line method over three years.”
And the Internal Revenue Service said, and on a letter to the taxpayer, we referred to as a letter ruling, it said, “On the face of it, these things look alright to us now.”
However, the Internal Revenue Service specifically said as we quote on page 2 of our brief, that this letter does not constitute a binding agreement under Code Section 167 (d) which sets up a system under which binding agreements maybe made.
But I might note parenthetically that even under Section 167 (d), if the facts change, the ruling is no longer valid.
And the Internal Revenue Service went on to state that the ruling was subject to such change in the event of subsequent experience should be different than expected.
So I think that disposes of the ruling as being binding.
In other words, basis of the facts as they existed in 1955 when this ship was acquired, that the Internal Revenue Service agrees with the petitioner that at that time, it's seemed reasonable that the ship would cost the taxpayer $420,000 to use it for three years.
Now Mr. Justice Fortas, an answer to your question, that taxpayers started out, and in the first year, it took a depreciation deduction based on those assumptions.
But by the end of 1957, he knew that the ship was not going to cost him $420,000.
He knew in fact that the ship had not cost him anything to use it.
Now, he'd already had depreciation deductions for 1955 for a month or so, and for the entire year 1956.
The Commissioner does not seek to go back and reopen those deductions.
In fact, the precedents would preclude the Commissioner, I think wisely so from doing that, because if the depreciation deduction was reasonable in light of the facts existing at the end of 1955 and the end of 1966, in light of the facts than existing, the Commissioner under the annual accounting system would not seek to reopen those facts as this Court said in (Inaudible) --
Justice Abe Fortas: Mr. Levin, excuse me.
I read this letter and on page -- page 65 of the agreement.
I must have misread what it says there, because as I read the paragraph on page 65 of the record, it's part of that letter, I thought that the phrase “subject to such change and subsequent experience” may were refer to the termination date and there is nothing in there that I found which says that it's not a binding agreement under the (Inaudible).
However that maybe -- however that may be, do you read that paragraph as relating to -- to refer to as costs and -- it's maybe cost or selling price.
Do you see what I'm referring to?
Mr. Jack S. Levin: Well, as I read both the Code and the regulation
Justice Abe Fortas: I want to know, I want to know what you said about that paragraph.
Mr. Jack S. Levin: Which paragraph, Your Honor?
Justice Abe Fortas: On page 65 of the record, which is the paragraph that I assume is referred then in your brief.
Mr. Jack S. Levin: Yes.
That paragraph says that the termination date of October 10, 1964 that refers to the three-year useful life is subject to such changes, subsequent experience may warrant.
Justice Abe Fortas: Now, does the -- has anything in the letter that goes beyond the termination date?
Mr. Jack S. Levin: No.
It doesn't specifically say that salvage value or resale price is subject to such change and --
Justice Abe Fortas: So that in your brief --
Mr. Jack S. Levin: -- subsequent experience may warrant.
Justice Abe Fortas: -- in your brief, on pages 2 and 3, it has to be read with that --
Mr. Jack S. Levin: No.
The brief specifically says that, Your Honor.
I'll quote from my brief on page 2 and 3, it says that the letter stated that the useful life was subject to such changes experience may warrant.
I specifically say that.
Now, I think its quite clear and I -- with Section 167 (d) of Code, it sets out a procedure whereby a taxpayer can ask for a binding ruling.
And if he gets such a binding ruling and he only gets such if it specifically says that it's pursuant to Section 167 (d); here the taxpayer may change the method of computing depreciation, that is either the useful life or the salvage value, unless the other gives notice -- states that the facts have changed.
There has been a subsequent change in the facts.
It makes it quite clear that even if this had been a 167 (d), which it which was not, because it didn't specifically mention this Section, that even in such an event, the Commissioner could have changed the salvage value, could have changed the useful life if the facts change.
Here the facts did change.
I don't think there's any contention that this ruling is more than advisory to the taxpayer, that it doesn't bind the Internal Revenue Service and prevent it from ever revoking it.
And in fact, this Court has approved retroactive revocations of rulings.
This was not a retroactive revocation.
No attempt was made to disallow depreciation in previous years.
Even the regulations themselves which certainly are governing here, and the taxpayers hasn't challenged their validity, the regulations themselves provide for changes in useful life and salvage value at mid-stream and depreciation where the facts changed.
Justice John M. Harlan: (Inaudible)
Mr. Jack S. Levin: Well, the --
Justice John M. Harlan: -- how about the regulations --
Mr. Jack S. Levin: The regulations --
Justice John M. Harlan: (Inaudible)
Mr. Jack S. Levin: The regulations specifically say that if at anytime during the life of an asset, there is a substantial change in the estimated period that the taxpayer will use it.
That is in the estimated useful life of the asset.
Then, at the end of the year in which these facts arise, that the depreciation deduction for that year and for subsequent years shall be recomputed.
Justice Byron R. White: (Inaudible)
Mr. Jack S. Levin: No.
I'll get to that right now.
Justice Byron R. White: (Inaudible)
Mr. Jack S. Levin: The regulations say that if the useful life changes substantially, the depreciation formula shall be recomputed.
The new useful life shall be used and at that time, a new salvage value or estimated resale price.
Justice John M. Harlan: (Inaudible)
Mr. Jack S. Levin: The new estimated useful life and resale price shall be used.
The regulations do not specifically advert to the occasion, to the events now before this Court.
That is what happens if there is no change in useful life, but merely a change in resale price.
Now, I have two answers to that Your Honor.
In the first place, there was a significant change in useful life in this case.
Taxpayer originally estimated he would use the asset three years.
He ended up using it exactly two years and thereto off either way.
That's a 33 and a third percent or 50% depending on how you compute it, reduction in useful life.
Justice Potter Stewart: It's not the useful life for the asset though, is it?
That's just how long he owned it?
Mr. Jack S. Levin: Well --
Justice Potter Stewart: I think of anything, the useful life -- life was prolonged by the artificial market created by this Suez crisis.
Mr. Jack S. Levin: Well, it again --
Justice Potter Stewart: Are you talking about -- more about concept like salvage value which is quite different.
Mr. Jack S. Levin: Well again, it depends on how you view the concept of depreciation.
We believed that depreciation is realistic in common sense attempt.
To allow a taxpayer to deduct over the period he actually uses an asset an amount of money equal to his actual cost, net cost if you will, of using that evidence.
Justice Potter Stewart: What's your, if I can interrupt and I apologize, useful life -- can we both agree, it doesn't have any -- useful life of an asset doesn't have anything to do much with how long a person owns that asset.
Mr. Jack S. Levin: No, Your Honor.
I would have to disagree with that.
In 1960, this Court decided the Hertz and Massey cases.
And now this case, as they said, useful life does not depend on the physical life of an asset.
Salvage value does not depend on the scrap value of an asset.
Rather that useful life depends on a period that the taxpayer expects to use the asset, and salvage value refers to the resale price he reasonably expects obtain for the asset at the end of his expected period of use.
Now, when this taxpayer acquired the asset, he reasonably expected to use it three years.
He reasonably --
Justice Potter Stewart: And then --
Mr. Jack S. Levin: -- expected to get $50,000 as scrap for (Voice Overlap) --
Justice Potter Stewart: As scrap, as salvage?
Mr. Jack S. Levin: That's correct.
Now, the reason at this Court said in Hertz and Massey, that useful life and salvage value were to be interpreted in this realistic and common sense way.
That is that it referred to the period that this taxpayer expected to use the asset.
And referred to the price he expected to receive on resale.
Justice Potter Stewart: Now that, as I understand as I recollect those cases, as I then understood them, the useful life to that particular taxpayer's business was short because his business required that the cars be relevantly late model cars.
Mr. Jack S. Levin: That's right.
Justice Potter Stewart: Isn't it true?
Mr. Jack S. Levin: That's right.
But, what I'm trying to get at here is the reason that this Court selected, not just in that one case but overall, selected the meaning for useful life and resale value realistically in terms of what this taxpayer expected to get for at the end rather than some scrap value that was artificial as this Court phrased it.
And that this -- this taxpayer didn't expect to sell the asset was because, I contend, that this Court recognized that depreciation was an inherently realistic attempt to allow the taxpayer to write off over his actual period of use, his actual cost for the asset.
And this Court said that at the beginning when you first acquire it, you must take realistic estimates.
How long do you really expect to use it and what you really expect to receive for it at the end, write off that realistically estimated net cost over your realistic period.
Now, here we are -- we are taking that, that very concept, that very thought one-step further.
We are saying in the year when the taxpayer finds out that the facts are different than he estimated at the beginning, if he has found out that he has written off the entire cost of his asset, he may not then take an additional cost, an unrealistic cost.
In the Massey case and in the Hertz case dealing with these depreciation questions -- well, I don't contend at all that those cases governed this case.
I contend that the principles that this Court discussed and used there are very persuasive here.
That court said that --
Justice Abe Fortas: (Voice overlap) determined as of the time of the acquisition of the asset at the beginning?
Mr. Jack S. Levin: That's right.
The regulation --
Justice Abe Fortas: What's you're saying is that this ought to be determined when as -- and if there is a sale of the asset at a higher price, and then now that the change in the salvage value ought to be taken into account by disallowing the depreciation the last year which I have a little difficulty in seeing -- you mentioned between that and the change in the salvage value --
Mr. Jack S. Levin: Well, I --
Justice Abe Fortas: -- as you don't re-compute the --
Mr. Jack S. Levin: -- depreciation for previous years?
Justice Abe Fortas: -- depreciation of this?
Mr. Jack S. Levin: No, Your Honor.
Justice Abe Fortas: You make some kind of an assumption, don't you?
Mr. Jack S. Levin: Well, Your Honor, I'd like to --
Justice Abe Fortas: And there is an equation between the two?
Mr. Jack S. Levin: I'd like to try to answer that in two steps if I can and I'll try to direct myself to your question.
In the first place, if a taxpayer buys an asset for a $100,000 and he figures he's going to use it for five years and he writes it off that he won't receive anything for it when it's all done.
He writes it off, $20,000 a year for five years.
Near the end of the fifth year, a war breaks out, an international crisis or some kind, and this machine we're talking about here, cannot be replaced.
He ends up using it, let's assume, another five years, it's quite clear that he doesn't get any additional depreciation for the remaining five years he used it.
And the reason is because, he's written off his entire cost.
Now, we contend that the purpose of depreciation is the eminently realistic one of allowing a taxpayer to write off, not his entire cost of the asset.
This Courts decisions in Massey and Hertz make come quite clear, that it's not intended to let you write off your entire cost of an asset, but just the cost you will actually incur.
That is your original cost less your salvage value or resale price.
Now, once this taxpayer knew, which he did at the end of 1957, that this asset hadn't cost him a penny, I believe he was in exactly the same position if the taxpayer would have written off his entire cost.
He knew he'd written off more than the asset cost because he got a $142,000 worth of depreciation in the previous two years and the asset hadn't cost him anything.
We think that to allow him to intentionally take depreciation that he knows he will never incur, it would distort his income.
We don't believe that depreciation was ever intended to serve his function.
When Congress enacted the allowance for depreciation, it said that a taxpayer should be allowed a reasonable allowance for depreciation.
Vague words, admittedly.
It then went on to say that the Secretary of the Treasury or his delegate would have authority to issue regulations and it -- depreciation would be computed in accordance with those regulations, that's Section 167 (b) of the Code cited in our Appendix.
Now we contend two things -- first, that the regulation specifically covered this case, not in so many words but the concepts in the regulations.
And second, that to the extent the regulations covered this case, they make sense, they are reasonable and they are in accord with the statutory purpose, as it's evident on the face the depreciation statute, and as it's evident from this Courts decision in Massey and Hertz.
The regulations -- and I'll state a couple of points and regulations very briefly, say first of all that the reasonableness of each year's depreciation deduction shall be judged on the basis of the conditions known to exist at the end of that year.
Now, what sense would there be in judging the reasonableness of the year's depreciation deduction, say five years after the asset was purchased, if not to see whether they were reasonable in light of writing off what this taxpayer knew or reasonably expected to be his cost.
Second, the regulations specifically state that no asset shall be depreciated below a reasonable salvage or resale value.
Now, we think that regulation itself is sufficient.
And third, the regulations give examples, instances we believe as I answered Mr. Justice White's question, where depreciation deductions -- depreciation formula will be recomputed and the salvage value or resale price will be recomputed.
They don't say that it will be in this case where you actually sell the asset, but we believe that the -- that it's a clear inference that whenever it's necessary in order to accurately take a reasonable allowance for depreciation, you must make that effort.
Now, I would like at this time to answer specifically Mr. Lewis' argument regarding the loss case.
He says, “This is a gain case, what about the loss case?
The same thing applies and it doesn't make sense.”
Now, we didn't answer that in our brief and so I'd like to answer it now.
He makes at point one of his reply brief, Mr. Lewis argues that by parity of reasoning and if this Court holds that once a taxpayer -- once a taxpayer has taken all the depreciation he's entitled to, which is what we're arguing here, then he's not entitled to anymore.
And if this Court holds that, then therefore this Court must also be saying that if the taxpayer sold an asset at a tremendous loss, then he must be entitled to take that entire loss as additional depreciation in the year of sale.
We don't believe that this necessarily follows.
In the first -- in the first place --
Justice Byron R. White: Let me get it; if you would agree -- you would agree (Inaudible)
Mr. Jack S. Levin: We do not believe --
Justice Byron R. White: Do you think (Inaudible)
Mr. Jack S. Levin: I'm going to explain why.
I think they may be treated differently.
We don't believe it necessarily follows that if the Government wins this case, the taxpayer wins the loss case.
We don't think that follows.
Justice Byron R. White: (Inaudible)
Mr. Jack S. Levin: As a matter of fact, the Commissioner has taken the position in a very few cases that have arisen, and there's only been a couple that the loss is not additional depreciation.
Certainly, after this Court makes its decision, the Commissioner may well have an opportunity to reexamine his position.
I don't suggest he's going to change his mind on it, but he'll have a chance to reexamine it, he'll have an opportunity to issue rulings or regulations.
As this Court said in the Lake case, P. G. Lake Case, they said the Commissioner can exercise his continuing rulemaking power.
Now once this -- that case has been decided, once the gain case has been decided, if the Commissioner then decides that the loss case should go the other way, I think there may well be reason for it to go the other way, as I'll state in just a moment.
The statutory test of course is a reasonable allowance for depreciation.
If a taxpayer buys an asset for a $100,000 and it depreciates at the rate of $10,000 a year for two years, so he's got an $80,000 un-depreciated basis in that asset, and then he sells that --
Justice Potter Stewart: You're assuming in what -- is that a ten-year life?
Mr. Jack S. Levin: Yes, a ten-year life and no salvage value, let's say.
So he starts out with asset that he pays a $100,000 and he takes $10,000 depreciation at the first year, and the second year, he's got $80,000.00 un-depreciated cost.
Then all of a sudden, by the end of the third year, he sells that asset for $10,000 -- it may well be that $70,000 is not in the statutory words, are reasonable allowance for depreciation for that third year.
On the other hand, we contend that if the taxpayer at the end of that third year sold the asset for $120,000, it's very clear that's this case.
It's very clear that no deduction for depreciation would be reasonable and that any deduction for depreciation would be unreasonable.
But, the statutory test on reasonable allowance for depreciation doesn't necessarily apply to the gain case and exactly the same way that it applies to the loss case.
As Mr. Lewis phrase it, he said, “Heads, we win.
Tails, you lose,” I don't think this is as easy as flipping a coin.
I think that this is case that -- the loss case, is not determinant of the gain case, I don't think the Government has to explain how it's going to treat the loss case or decide that now.
Chief Justice Earl Warren: Mr. Levin, Mr. Lewis is very precise about what the administrative interpretation has been from 1913 up to 1960.
What is your answer to that?
Mr. Jack S. Levin: I'll take the issue with this interpretation, Your Honor, I'll state it very briefly here but it's contained a great length in the brief.
First of all, it's quite clear that during a large percentage of the eras from 1939, it made no tax difference in the world whether depreciation was allowed in the year of sale or not because the vast majority of the case as cited by Mr. Lewis are cases where the taxpayer received ordinary income on his sale of the asset.
That meant that if he took a depreciation, let's say of $135,000 in the year he sold the asset, that reduced his operating income by $135,000.
Since that reduced the basis of his asset by $135,000, it increased his gain on the asset by a $135,000.
If that gain was taxed to his ordinary income, then all he did is take a $135,000 of operating income and put it into gain on the asset.
And both were taxed exactly the same way, his ordinary income.
Thus, the Commissioner would have been laughed out at the court if he'd brought a case and said, “Well, this taxpayer put the $135,000 worth of income in the wrong place on his return.
But the tax result is just the same.”
Mr. Lewis cited the Ludey case, decided by this Court in 1927, the Crane case decided in 1947, and he mentioned another case in 1921, all three of those cases related to years in which it made no difference whatsoever how you computed the allowance for depreciation, and that's why the Commissioner didn't focus on the issue.
I admit that there were approximately, I believe, eight cases according to Mr. Lewis' own brief, his reply brief, approximately eight cases during the entire history of the Internal Revenue Code in which it would've made a difference and in which the Commissioner didn't seek to disallow the depreciation.
But there was no focus whatsoever on the issue.
These cases came shortly after the change in the Code had made the -- had made the gain on an asset, capital gain.
They came at a time when the Commissioner was seeking to lay down the basic ground rules of the Code.
They all involve cases such as whether depreciation was allowable at all on a given type of asset rather than how you -- exactly, how under my new way you compute depreciation from what date to what date.
They involved broad-sweeping questions and sometimes on constitutional issues such as whether in the given case, depreciation should be computed on the basis of the cost of the asset or its value on March 1, 1913 when the Code was enacted.
All of those cases involved other issues, complex issues and neither the courts nor the Commissioner focused on it and it's the --
Chief Justice Earl Warren: When did the tax structure first bring this problem into focus?
Mr. Jack S. Levin: There was some capital gain on assets beginning in the year 1921.
However many of the cases decided after that here concerned previous years for another eight or nine years at least that litigation concerned pre-1921 years, in which no one had ever heard of capital gain.
Moreover, even after 1921, there was a capital gain in only some assets and the vast majority of the cases cited by Mr. Lewis dealing with those later years also concern cases in which the particular asset involved produced ordinary income.
Now in 1938, Congress repealed capital gain for depreciable assets altogether.
And from 1938 to 1942, there was no capital gain on the depreciable asset.
Thus, every case involving depreciable assets -- this issue was mooted.
That's the era out which the Crane case grew.
Now immediately after or shortly after 1942, when this issue again became revitalized by virtue of the change in the statute in 1942 giving capital gain on the sale with depreciable assets, the Commissioner began to focus on it.
The Commissioner disallowed year of sale depreciation in two cases that we discussed at length in our brief, one involving 1942 depreciation itself, the first year after the change in law, another involving 1944 depreciation.
Now, I'm frank to admit that the Commissioner probably did not instruct his thousand of agents to go out and seek out cases, somehow, these two arouse, and the Commissioner disallowed the depreciation -- 1942 and 1944.
Those cases were hardly litigated.
The 1942 case, the Weir Long Leaf case resulted in a confusing decision of the court, somehow upholding the Commissioner on part of the assets and not upholding him on the other.
We can argue over whether those issues are reconcilable.
I don't think they are.
But one thing is clear.
The Commissioner had taken the position that the depreciation should be disallowed.
The other case finally went up to the Court of Appeals.
That's the case involving 1944 depreciation and the Commissioner won the case, that's the Cohn case.
Now, after winning the Cohn case, the Commissioner then issued a Revenue Ruling which specifically stated the principles that we are here relying upon for broad application.
And then I'm sure Revenue agents all over the country somehow got wind that this was an important issue, and now there are approximately 300 or 400 cases pending.
We did not believe that the Commissioner's failure to focus upon or consider the issue precludes him from first raising it in 1942.
In fact in a 1927 case, which I mentioned only because -- not because the issue was really genuinely focused -- in a 1927 case mentioned by Mr. Lewis in his oral argument, the Commissioner disallowed depreciation in the year of sale.
The court held against him, but he had disallowed the depreciation.
And again, it was not raised again by the Commissioner until 1942 depreciation came into existence.
But in essence, before I sit down, let me just say that we contend first, that the Commissioner is not precluded by the re-enactment doctrine, we don't think the Commissioners failure to raise the issue for a few years really came to the attention of the Congress or can be deemed by this Court in light of the precedents cited and quoted in our brief to have caused the Congress to make a considered determination that a reasonable allowance for depreciation should not be interpreted as the Commissioner now interprets it.
Certainly, the Congress didn't consider this.
In fact, the only congressional reference to it was in 1964 committee reports where the Congress specifically said that it did not intend to overturn the holding of the Second Circuit in the other cases, which went in the favor of the Commissioner.
The Congress said that in the 1964 committee report and that's quoted in our brief as well.Second, we contend that once this Court reaches the issue on the merits, that the result should be in favor of the Commissioner because the whole history and purpose of depreciation as well as the regulations make it quite clear that a taxpayer should not knowingly be allowed to deduct a cost he knows he will never incur.
We think it would intentionally distort his income and we contend that it would not be reasonable allowance for depreciation.
Chief Justice Earl Warren: Mr. Lewis.
Rebuttal of James B. Lewis
Mr. James B. Lewis: May it please the Court.
I agree that we have the other question of what is a reasonable allowance for depreciation.
What does petitioner had on January 1, 1957 was two assets.
He had the use of the ship for scrap, a potential use for scrap on which the parties agree -- to which the parties agree $54,000 of the costs should be allocated.
He had the predicted two remaining years of use as a cargo carrier based on a determination that both parties also agree on.
And the balance of his cost $270,000 must have been the cost of what he was going to use after that two years.
He consumed one of the two years and then he sold to a competitor the right to use the vessel for the second of the two years plus the scrap value.
The petitioner took the $270,000 of remaining cost fairly attributable to the usefulness of the vessel as a cargo carrier and applied half of it against the 1957 year he used up, and he applied half against the 1958, year of you see it sold.
The Commissioner says, “No, zero to 57th year of use, $270,000 to the 58th year of use.
That cost you $270,000, 1957 cost you nothing.
Now, which is reasonable?
Take one case just to focus on the issue.Suppose that I own a patent that I had purchased and it has two years to run.
And I have under a fair allocation of cost set up by a ruling, $270,000 of un-recovered cost and I have two years to go, and then it's worth zero, absolutely worth zero.
Which should I do if I use one year, if I consume ‘57 and get the ‘57 royalties, make money for ‘57 and then sell the to you the right to receive the ‘58 royalties, shall I apply $135,000 to ‘57 and $135,000 to 58?
Is that reasonable?
Or is this reasonable?
Now the Commissioner gets there by inventing an argument that's utterly circular, utterly unsupported, he's made it up as though this were field of pure reason, no history, and he says, “History is not on the merits.”
And then having ventured into this field of pure reason, he reasons so badly that you get this preposterous result of one year costing nothing and the second here costing everything, nothing could be more unreasonable than that.