COMMISSIONER v. IDAHO POWER CO.
Legal provision: Internal Revenue Code
Argument of Keith A. Jones
Chief Justice Warren E. Burger: We’ll hear arguments next in 73-263, Commissioner against Idaho Power.
I think we’ll wait a little while Mr. Jones until the bleachers is clear.
Mr. Jones, I think you can proceed whenever you are ready now.
Mr. Keith A. Jones: Mr. Chief Justice and may it please the Court.
This case raises a question of business income taxation under the internal revenue code of 1954.
The respondent taxpayer, the Idaho Power Company is a public utility engaged in the production, transmission and distribution of electric energy.
In connection with this business, the respondent performs a substantial proportion of its own -- substantial portion of its construction work.
In the years 1962 and 1963, the tax full years in question in this case.
The respondent itself constructed approximately $13,000,000.00 in new capital facilities primarily --
Justice Harry A. Blackmun: Put you back along way Mr. Jones, I suppose the same issue is at present time, succeeding tax full years of the taxpayer?
Mr. Keith A. Jones: That is my understanding Mr. Justice Blackmun.
In performing this construction work, the respondent uses essentially two different types of construction equipment.
Uses automotive transportation equipment such as passenger cars, pickup trucks, heavier trucks and trailers and also what is called power operated equipment, which means primarily cranes, tractors, bulldozers, road graters and so forth.
The depreciation of this construction equipment, well in this case be referred to as construction -- excuse me construction related depreciation.
Now by construction related depreciation, we do not mean all depreciation on construction equipment but we refer to in this case as the depreciation on construction equipment used by taxpayer in the construction of its own capital facilities.
In performing construction work, the respondent encourage a wide variety of construction cost.
It pays wages to construction workers, it buys tools and materials which are used up in the course of construction, and it also incurs wear and tear or exhaustion of the construction equipment itself that is the construction related depreciation.
On its general looks of account, the respondent capitalizes all of this construction cost.
It does this in compliance with generally accepted accounting principles which recognize that this construction cost including construction related depreciation constitute capital outlays and not operating expenses.
This fact is also recognized by the federal power commission and the Idaho public utilities commission, both of which require the respondent to capitalize its construction related depreciation and for regulatory purposes.
However, on its tax returns, the respondent treats these matters somewhat differently.
It capitalizes most of its construction cost.
For example, it capitalizes the wages paid to the operators of the construction equipment, does not deduct those wages as an ordinary unnecessary cost of doing business.
It also capitalizes the cost of fuel used by the construction equipment and it capitalizes the cost of repairs to that equipment but it does not capitalize the depreciation itself.
It seeks in this case to take that depreciation as an immediate deduction against current income.
The commissioner disallowed this depreciation deduction for the years in question and the tax court sustained that disallowance on the ground that Section 263 of the code requires the capitalization of all capital cost including construction related depreciation.
However, the court of appeals of the Ninth Circuit reversed.
I think it is fair to say that the opinion of the court of appeals came to a surprise, came as a surprise to many tax practitioners.
Internal revenue service has for many years taken the position in formal rulings that construction related depreciation must be capitalized and it is not deductible.
In this position of the commissioner has been upheld in a long series of decisions in the board of Tax Appeals, the Tax Court and the Court of Claims.
Because of this long history, almost all taxpayers who are engaged in the self construction of their capital facilities have complied with the services rulings and have capitalized their construction related depreciation.
This long acceptance of the commissioner’s position makes the immediate revenue impact of this case quite substantial.
Most railroads and utility companies and many large industrial corporations as well perform their own construction work, and as I have said, these taxpayers have in the past capitalized this depreciation either.
But if the decision below were left standing, it was anticipated that most of this taxpayers would file claims for refund on the basis of that decision and the Rnternal Revenue Service estimated that this refund claims would amount to over $100 million for each of the tax full years currently open.
And it was in large part to forestall the litigation which would arise from the filing of those refund claims that the government petition for certiorari in this case.
I turn now to a discussion of the merits.
It should first be pointed out that the deduction which the respondent seeks in this case would result in a distortion in the reporting of its net income.
Construction related depreciation is not an operating expense, it is a capital cost associated with the production of income only in the future, not with the production of income in the present.
The cause of that, the deduction of this depreciation, we tend to understate current net income and it would postpone or defer the recognition of income which the respondent has already earned.
In other words, what the respondent is claiming in this case is the right to take an immediate deduction which is not sanctioned by normal accounting rules which would have the effect of postponing the recognition of income until future years.
This Court has never permitted such deductions of amounts which were not sanctioned by normal accounting rules which would have the effect of so postponing the recognition of income except whereas such a deduction is clearly allowed by the explicit language of the statute and it is our position here as I will now go on to discuss.
Statute does not permit the deduction of that item in this case.
Justice Byron R. White: What do you rely on, saying this is not normal if it would not be normal accounting practice?
Mr. Keith A. Jones: By normal accounting practice we mean the general accepting accounting rule that this kind of capital cost must be capitalized.
Justice Byron R. White: I know that what you say but what is your authority to that?
Mr. Keith A. Jones: Well, we sited a couple of accounting text in our brief and we also sited the rules --
Justice Byron R. White: Having books of this company kept --
Mr. Keith A. Jones: They were kept on the basis which we urge.
In other words, they capitalize the construction related depreciation.
Justice Byron R. White: So their own accounting, for the purpose of its audit and its certificate, treated this as you suggested should be treated?
Mr. Keith A. Jones: That is correct Mr. Justice White.
Justice William O. Douglas: Does the SCC have an accounting rule on this?
Mr. Keith A. Jones: Mr. Justice Douglas, I am not familiar with the SCC’s rules that may but I can answer that question.
However, the Federal Power Commission which regulates this company does have a rule which requires capitalization and the Idaho public utilities commission also a regulatory agency that which respondent to subject also requires capitalization.
Chief Justice Warren E. Burger: It is not unusual I suppose for a taxpayer to treat an item one way for its internal accounting purposes and another way for taxes.
Mr. Keith A. Jones: There is nothing about that Mr. Chief Justice.
Unknown Speaker: Or unconstitutional.
Mr. Keith A. Jones: We are not relying upon any constitutional claim in this case.
Unknown Speaker: And all depreciation taken back a company on his books says does not allow for tax purposes.
For example, where prop is just put on books on the basis of an appraised value, that if the accountants will depreciate right up annually and of course you can’t take any deduction for the tax purposes.
Mr. Keith A. Jones: Certainly no deduction.
Certainly where the Section 167 which governs depreciation generally would not permit a deduction, the tax payer could not take such deduction merely because he took it on his general books of account.
Unknown Speaker: That’s the only point I’m making.
That the fact the tax payer took is not necessarily a controlling in that situation.
Mr. Keith A. Jones: But he only took it on his tax returns in this case.
Taxpayer here did not take the deduction on its general books of account.
Unknown Speaker: Right.
Mr. Keith A. Jones: I turn know to an analysis of the statute which must begin with Section 263, that section provides and I shall quote “no deduction shall be allowed for any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or a state.”
It is our position that this is not a technical provision to be read narrowly.
To the contrary, this court has historically read it broadly as the legislative expression of the accounting principle of capitalization.
This court has recognized that in the course of holding such diverse items is Brokeridge commission, stock appraisal litigation cause and supplementary savings in loan insurance, premiums to be capital.
That Section 263 stands for the broad requirement that capital items must be capitalized.
They are of course statutory exceptions to this broad requirement.
Section 263 itself contain several such exceptions.
Also Section 266 provides an exception for taxes and caring cause.
But there is no similar exception for depreciation.
There is nothing in the code which would accept depreciation in the requirements of Section 263.
There is to be sure provision for the deduction of depreciation.
That is allowed in Section 167.
As we pointed out in our brief, Section 161 of the code expressly makes all business deductions including the deduction for depreciation under section 167 subordinate to the capitalization requirement of Section 263.
In other words, if this construction related depreciation falls within the general terms of Section 263 that it must be capitalized not withstanding the fact that it might otherwise be deducted under Section 167.
We believe that to view the matter in this slight is practically to answer the question presented.
Because it is undisputed in this case, the construction related depreciation is a capital item.
It is undisputed in this case, the construction related depreciation is a cost of construction and the regulations under Section 263 have historically acquired the capitalization of all cost of construction.
Moreover, as we have pointed out in our reply brief, the regulations under Section 48 expressly state the requirement that construction related depreciation must be capitalized that it is not subject to immediate deduction.
The respondent therefore is essentially in the position of contending that the secretary’s regulations misconstrued the statute.
But in making this contention, the respondents following far short we believe of carrying the burden or showing that the secretary’s regulations are unreasonable.
The only statutory argument which the respondent makes in this case is the depreciation does not “an amount paid out” within the meaning of Section 263.
On the first place, we believe that this argument overlooks the fact that this court held in Lincoln savings and loan that capital items must be capitalized whether or not they might fall within a strict reading of the literal language of Section 263.
We need not reach so far in this case because we believe it’s clear that construction related depreciation is an amount paid out within the meaning of the statute.
The secretary has construed that statutory phrase, amount paid out to mean as being synonymous with cost incurred.
And that is really the only construction in the statute that makes any sense.
That is the only construction in the statute which harmonizes the fundamental assumptions of the income tax system.
Congress could have not required the capitalization only of actual payments, could not have intended that only actual payments be subject to capitalization.
Historically, items such the issuance of stock, assumption of liabilities, the using up of construction materials, the exchange of property for other property has given rise to capitalization has not been immediately deductible even though there is no actual payment that is taking place at the time that the capital asset is acquired.
What is important under the statutory scheme is simply that when a capital asset is acquired, there will be some cost incurred, liability assumed rather responsibility undertaken which properly is a capital item.
And in this case, the respondent by using out its construction equipment by physically exhausting that equipment has incurred a very real cost in the coarse of acquiring a capital asset, and that cost which is incurred gives rise to the capitalization requirement here.
But even if the statute were read literally as requiring actual payment, it nevertheless does not require that payment to be made during the taxable year in question.
Thus, when the respondent pays or incurs wage expenses in the course of constructing capital facilities and those wages aren’t paid out until the following year.
Nevertheless, there is a capital item in the first year, there is no actual payment, payment is made in the following year but it is the accrual of the wages in the first year which gives rise to a capital item but perhaps more to the point in this case.
If the respondent purchases construction materials in one year and then uses up those construction materials in the two following years, when those construction materials are used up, that is a capital item which has to be capitalized as part of the basis of the capital facilities which are being constructed.
And depreciation really is exactly the same as the consumption of these construction materials.
The payment is made in the first year when construction equipment is acquired.
But as the construction equipment is used up, depreciated, there gives rise to the capital item in exactly the same way as they using up of construction materials in subsequent years thus.
In each case, you have a payment in an earlier year, but the using up of the asset which you have already paid for in the course of constructing your new capital facilities and all of this physical exhaustion or usage of materials as part of the cost of construction represents an amount paid out within the terms of the statute and as a capital item.
We feel that this conclusion is supported by other provisions of the code.
In our reply brief, we sited Sections 174, 182, 615, 616 and 617.
All of these provisions permit a taxpayer to deduct items which would otherwise have to be capitalized.
And each of these provisions does permit the deduction of construction related depreciation in very limited circumstances.
We think it is clear that the congress by providing for the deduction of this kind of depreciation in those limited circumstances express this in -- in the first place it expresses awareness as such depreciation would otherwise be capital item not subject to deduction.
And secondly, it indicated its intention that in all other circumstances not covered by those provisions, this depreciation would still be subject to capitalization and would not be a deductible item.
And finally, I would like to emphasize that all we are trying to do in this case is to achieve a tax parity between this taxpayer and all other taxpayers who acquire capital facilities.
And I think that can be seen to the following examples.
Justice Potter Stewart: Because they do not do their own construction work you mean?
Mr. Keith A. Jones: Well, I will give you several examples Mr. Justice Stewart, some of the taxpayers who do and some who do not.
For example, if the respondent in this case had rented this construction equipment instead of purchasing it and use rented equipment in constructing its own facilities, those rental payments would all be capital, none of them could be deducted immediately and all be part of the new capital basis of the new facilities.
Similarly, if this respondent form the subsidiary corporation to construct the assets that kept new facilities.
Although that subsidiary corporation would be entitled to a depreciation deduction, under Section 482 of the code.
Justice Potter Stewart: If the subsidiary corporation were in the construction business, it would be entitled to a full depreciation deduction from its ordinary income and --
Mr. Keith A. Jones: That is correct but --
Justice Potter Stewart: And they would depreciate without a question wouldn’t it?
Mr. Keith A. Jones: Under section 482 of the code, the parent corporation would be required to pay the subsidiary enough to offset that depreciation so that the deduction would not give the subsidiary any advantage, it would simply be a wash and the payment made by the parent to cover that depreciation would be a capital item, would not be deductible to the parent because it will be part of the cost, the parent expanded and bind the new capital facilities from the subsidiary.
And that of course where an outside independent contractors hired to do the work, all the payments to that contractor including amounts necessary to cover depreciation on the contractors equipment would be capital, they will not be deductible.
Justice Potter Stewart: Although the contractor himself demanded a contracting business could not mislead the pre state.
Mr. Keith A. Jones: That is right, and that points out the underlying thesis of our position where depreciation is incurred for the production of immediate income, then it is an expense of operations which is properly deductible.
When it is incurred however, not for the -- not in the course of an ongoing business to produce immediate income but to acquire a new capital asset which is only going to be used for the production of income in the future, then it is a capital item.
For these reasons, we asked the court to reverse the judgment of the court of appeals and I would like to reserve my remaining time.
Chief Justice Warren E. Burger: Very well Mr. Jones.
Argument of Frank Norton Kern
Mr. Frank Norton Kern: Mr. Chief justice and may it please the Court.
In this case, Idaho Power Company uses its own equipments such as trucks, cranes, etcetera in part for operations and part for maintenance and in part the construction of its own capital facilities.
That equipment has a life of approximately 10 years.
It is in the position of the taxpayer that should be entitled to deduct depreciation on that equipment over its life of 10 years.
While it is the position of the government that such depreciation should be capitalized and added to the cost of the facilities produced which had a life of more than 30 years so that the government’s position is that the depreciation on the equipment used in construction should not be deducted over its 10 year of life but instead in aggregate over a period 40 years which would mean that the taxpayer couldn’t recover depreciation, couldn’t recover the cost of this property by depreciation for a period of more than 30 years after the property was no longer in existence.
Now, there are several plot -- we believe that the answer to this questions turns not upon a question of accounting but it turns on a question of interpretation of the provisions of the Internal Revenue Code.
Section 167 under one hand, which allows the deduction for depreciation of property used in trade or business, in Section 263 on the other hand, which requires capitalization of any amount paid out for new buildings or for permanent improvements or for betterment to increase the value of any property or state.
Now, turning first however since much has been made to question of accounting in the briefs, I would like to speak just momentarily to that.
This is not a question of the taxpayer’s accounting per books under Section 446 of the Internal Revenue Code.
That section basically provides a taxable income shall be computed in accordance with the way the taxpayer keeps its books but under the regulations applicable to that section, Section 1.446-1A1, it is stated that certain special items for which the Internal Revenue Code provides its own rules are not to be computed in accordance with the way the taxpayers keeps its books and included among those as such things as research and experimental expenditures and appreciation, etcetera.
So this isn’t a question of the way that we keep our books, the taxpayer keeps its books.
And parenthetically there, I would like to state that there are many things besides depreciation that are considered to be expenders that they -- that could be considered to be cause of property constructed that the taxpayer does not capitalize.
These weren’t mention I don’t know why because they keep appearing in the briefs but in the briefs, it was mentioned taxes, pensions, those things.
We didn’t think it was important but all taxpayers in a profitable position deduct interest during construction and the Internal Revenue Code has always permitted taxpayers.
The permission of this deductions and interest and taxes could be deducted regardless of the existence of section 263 and the Internal Revenue Code since 1913, since the code came -- since the predecessors, the code came into existence and they were not made deductible by Section 266 as the government would suggest.
They were deductible because -- before Section 266 came in which permits capitalization of interest in taxes if the taxpayer elects to capitalize it.
So there are whole series of things that can be deducted under the Internal Revenue Code, under the provisions of the code that possibly from question of good accounting should be capitalized.
Turning specifically to the question of financial accounting, it is suggested by the government that depreciation should be capitalized because it is good accounting to capitalize in the certain tax are sided to that effect.
However, it is respectfully suggested that the government would not be willing to accept all of the various types of rules that they’re applicable under financial accounting on the one hand and the tax accounting does not accord with financial accounting on the other.
For example, the government referred in its reply brief to accounting research bulleting number 43, which was issued in 1961 by the American Certified -- American Institute of Certified Public Accountants.
Now, in 1961, in that particular bulletin that is pointed out that as cost increase, as the cost of replacing, equipment increases as equipment is improved, as inflation occurs, historical cost of depreciation does not provide a fund for replacement of equipment and it is stated in that particular bulletin that it is proper for management to make an annual appropriation of net income and contemplation of replacement of such facilities at higher price levels.
This is what financial accounting does in addition to the deduction for depreciation in order to reflect properly.
The cost higher expenses on its books.
Now, of course the government would not accept that.
From the government’s point of view, that would be the creation a contingent reserve which has not been deductible certainly since the decision of this Court in Brown v. Hovering in 1934.
So I don’t think that the government is really understood and having all of the concepts of financial accounting from applied for tax purposes.
Moving ahead however, under the tax law, there are specific accounting rules which are really indicated -- really proper rules indicated by Congress in adapting the provisions applicable to depreciation.
Congress recognizing as long ago as 1954, that there were increase cost of replacement of equipment that the method of depreciation at that time did not permit recoupment of the cost of assets in the expansion of American business provided for methods of accumulating funds more rapidly so that the funds -- accumulating funds more rapidly by depreciation so those funds could be used in the business to earn other funds and replace equipment or could be used for expansion.
For example, in 1954, various methods have accelerated depreciation were permitted including declining balance depreciation at twice the straight line rate and that would allow the deduction of approximately 40% of the cost of equipment in the first one quarter of its life for about two thirds of the cost equipment in the first 50% of its life and then added to that, coming ahead up to the present time, Congress in 1971 adapted the asset depreciation range system and that particular system permits taxpayers to adapt a class life which is in the first 30th percentile of lives previously used by taxpayer’s in the best, that is the bottom 30, the quickest 30 and then to reduce that life by 20% and then to apply accelerated methods of depreciations so in the case of a five year property such as lave for example, a taxpayer can deduct 50% of the cost and that late in the first taxable year.
Now, this are the kinds of rule that apply to tax depreciation and they are much more consistent with the deduction of depreciation on the taxpayer’s equipment over its own useful life as suggested by the taxpayer than requiring the taxpayer to deduct depreciation on that equipment, not over its own useful life but not until a period of 30 years after the equipment is no longer in existence.
The taxpayer has as much need for funds to replace that equipment, those automobile so as the cranes that it uses for construction at the end of their useful lives at it has for as any taxpayer has for a need to replace any other equipment and the reasons for such replacement are the same.
Justice William H. Rehnquist: Mr. Kern, are the automobiles that you referred to are they used by the company a 100% of the time in construction or they use part of the time for construction, part of the time for other.
Mr. Frank Norton Kern: And part for operations and part for maintenance and in part for construction.
Justice William H. Rehnquist: You understand what the governments position is as to how that should be allocated or whether it should be allocated.
Mr. Frank Norton Kern: Yes, the company keeps records on its books as to the usage and those records are available in an allocated portion of the depreciation as allocated to construction.
Now, it is the position of the taxpayer, that this question is properly a question of statutory interpretation of Sections 167 and 263 as Congress manifested its intention in adapting those Sections.
Now, to bring this out, we have to go all the way back to beginning since these sections have been in the Internal Revenue Code for the first, we go all the way back to the Civil War Act of 1864, and the legislating predecessor of Section 263 first appeared in that Civil War Income Tax Act which provided that no deductions shall be made for any amount paid out for new buildings, permanent improvements or betterments made to increase the value of any property or a estate almost exactly the same words that are used today in Section 263.
Now, quite clearly, at that time, these words were not intended to disallow deduction for depreciation because there was no concept of depreciation at that time.
Depreciation was not a deduction under the Act of 1864 and depreciation accounting as pointed out by Mr. Justice Brandeis in united railways and electric company of Baltimore v. West did not come into use in the United State until after 1900.
Now, I do not mean to say that the Civil War Congress is intention.
This carried over up to the present time.
What I do mean to suggest is that then in 1913 with that going through all the acts of that particular time but in 1913, the Revenue Act of 1913 which is probably the direct predecessor of the present Income Tax Law.
Congress chose to adapt exactly this same language to require capitalization.
That is no deduction shall be made for any amount paid out for new buildings permanent improvements or betterments made to increase the value of any property or estate.
Now, this is we believe important because in the same act, Congress indicated its concept of depreciation.
It stated in that act a deduction shall be allowed for loses actually sustained including a reasonable allowance for depreciation so that in this Revenue Act of 1913 under one hand, Congress indicated that a thought depreciation was a lost in value or a decrease in value much as it has been described by this court in numerous decisions such as the Lodi decision 1927 or Maci motors 1960 and other decisions that Congress thought it was a reduction for loss or decrease in value under one hand depreciation was and on the other hand, it required capitalization only of any amount paid out for new buildings or permanent improvements or betterments made to increase the value of any property or estate.
Now, this situation is the -- this exact language continued up till 1918 when the lost deduction and the depreciation deduction were separated.
And then head up to the present time, essentially the same situation has continued but we believe that there is further indication that up to the present time, Congress has continued to intend that depreciation shall not be considered an amount paid out and shall not be capitalized but instead as regarded as a reduction or lost in volume.
And the reason we believe that is that we site the opposite side I guess it is the same sections, Mr. Jones pointed out what we said it at first in our briefs.
The -- wherever Congress has intended that depreciation shall be treated as the equivalent of an expenditure, a word that is also used in Section 263 at the present act, the equivalent of an expenditure or of an amount paid, it has found it necessary to provide a definition in the section of the code to that effect, while on the other hand, where it has not intended that depreciation shall be considered an expenditure or an amount paid, there is no definition throughout the internal revenue prior to that effect.
Now, Congress has not found it necessary to define expenditures or amount paid in any other respect except in its consideration of depreciation.
And in Sections 174 having to do with research and experimental expenditures in Section 182 having to do with farm clearing expenditures, 615 and 617 having to do with exploration for minerals and 616 mind development expenditures and each of those cases where Congress has intended that depreciation shall be treated as an expenditure as it uses the words for the effect but allowances for depreciation shall be considered for purposes of this section as expenditures paid or incurred and on the other hand, this has not been down for any other type of deduction but on the other hand where Congress does not intend that depreciation shall be considered an amount paid or the equivalent of an expenditure, it does not so provide.
For example in Sections 170 and 213 which have to do with charitable contributions and medical expenses, there is a deduction allowed for an amount paid or a payment and that neither of these sections is the word pave their payment defined to include depreciation, and that neither of this sections is it treated by the Courts as including depreciation.
The case has come up in the use of automobiles and where an automobile is used for a medical or a charitable purpose, deduction is allowed for the gas, the oil, the maintenance, insurance and all similar expenditures but no deduction is allowed for depreciation on the automobile because it is not considered as payment or an amount paid.
Now, of course, Section 263 does not have any definition to the effect that amount paid or expenditure shall include the term depreciation and we respectfully suggest that in light of the legislative history of Section 263, in light of the way it has been used since it first came in to the Internal Revenue Code that Congress did not intend that the terms amount paid shall include depreciation as that within the scope of Section 263 and therefore depreciation need not be capitalized.
Now, I would like to turn to one other facts that the government has in its briefs and Mr. Jones briefly pointed out to the effect that there was a long and consistent administrative history requiring capitalization and depreciation, I respectfully suggest that that is not true.
Section 263, the section that requires capitalization came into code in 1913 and also did the allowance for depreciation.
Going back to administrative history, administrative history itself if you regard that as regulations or rulings or that sort of the thing, the government did not say a thing about capitalizing depreciations on 1955 but looking at administration is perhaps encompassing what the government litigated.
Back in the 1920s, there are four railroad cases in which concerned in a sense they have been sited as concerning the requirement for capitalization and depreciation and what in fact they concern was the movement of men and materials in work trains to a location in which the railroads were constructing new facilities.
And apparently buried in the cost, the cost of this movement was accounted for on the books by saying that it was one cent per man, mile per man and six tens of a cent per ten mile for materials.
Buried in that cost was an element of depreciation.
Now, the government at that time stated that the railroads had to capitalize the cost of moving man and material to these locations.
Justice Potter Stewart: These are tax cases or ICC cases?
Mr. Frank Norton Kern: These are tax cases.
Justice Potter Stewart: Tax cases.
Mr. Frank Norton Kern: But it was the -- of course it was the ICC accounting that got depreciation buried within it.
Justice Potter Stewart: Right.
Mr. Frank Norton Kern: The government said that these cost had to be capitalized and the Court four times, the Court’s four times, each time it started off for the board of tax appeals held that they must be capitalized but in only in one of those cases was the term depreciation ever mentioned.
And then it was just more or less mention in passing.
There was no discussion, no analysis of the code, no consideration of Sections 263 and 167.
Now, coming down ahead up after those four cases, the government then came upon a case for the railroad at which it had used the equipment to construct its own facilities and in a great northern case decided in 1934 by the board of tax appeals and the government took the position that that depreciation should be capitalized.
This was the first case directly concerning the matter.
Now, the case was actually argued, the government never took the position of section 263 requires that it be capitalized or its predecessors they do today.
It was actually argued on the question of whether or not construction was part of their railroads trade or business and the court held that it was and the depreciation was permitted to be deducted.
And then you go ahead up to 1955 and its 40 years since 1913 and at that point, it came out a revenue ruling that said to the effect that taxpayers had to deduct the -- or had to capitalize the cost of planting trees that they were engaged in forestry and that included depreciation on the planting equipment and there was a similar rule, a few revenue ruling not a regulation a revenue ruling a few years later concerning the capitalization of depreciation which again did not rely on Section 263, it relied on a case that said that construction was not part of the taxpayer’s trade or business and I might say of course to make it clear that that question isn’t before us today because the government has conceded that the construction by Idaho Power Company, all of its facilities is part of its trade or business.
Unknown Speaker: Mr. Kern, let me get that straight, the government has conceded it is part of the trade or business?
Mr. Frank Norton Kern: Yes. I believe that is what’s made most clear on the reply brief at page nine in that footnote.
Unknown Speaker: But what they haven’t conceded is whether it is the principle trader business, is that the distinction?
Mr. Frank Norton Kern: No, what the -- I think the government concedes that Mr. Jones I am sure will correct me, I think the government concedes that this property, that the property used for construction wouldn’t be depreciable and it’s use for construction under Section 167, but that depreciation is so far were entitled to the depreciation, but that depreciation must be capitalized under Section 263.
Unknown Speaker: I assume there is no question about.
Mr. Frank Norton Kern: No questions that. We’re --
Unknown Speaker: The government’s concern.
Mr. Frank Norton Kern: We are arguing that Section 263 historically was not intended by Congress to disallow or to apply to the deduction for depreciation because the depreciation is not an amount paid out by its terms Section 263 requires only capitalizations of amounts paid out.
So that is where the point of departure is.
When I was discussing whether or not there was a long and consistent administrative history, coming then and up to 1913 to 1955, the government first asserted that depreciation should be capitalized anyway in 1955.
In 1958, the regulation which Mr. Jones refers was issued that is a regulation 1.263 2 A and that regulation sets forth examples of cost which the government state should be capitalized and include therein cost of acquisition, construction, or reaction.
Now, this is an example of that which should be capitalized under Section 263 and immediately before that, the regulations repeat the mandate of 263 that is that capitalization is required only of any amount paid out for new buildings or betterments etcetera.
But the regulation does say that cost should be capitalized as respectably submitted in no place says that depreciation must be capitalized or that depreciation shall be treated as a cost for the purpose of Section 263.
Actually, the term cost is applied in the Internal Revenue Code.
Means that which must be capitalized under the code because certain items we would ordinarily consider to be cost perhaps from a popular or economic point of view maybe deducted and certain maybe capitalized so that cost as used in the regulations necessarily refers only to those items which must be capitalized.
And then following ahead along through the regulations, up the last word which the treasury department has issued concerning the whether or not depreciation should be capitalized has to do with the investment credit.
Now, the investment credit has allowed under Sections 46 and 48 has allowed as a percentage of the basis of property constructed or acquired including property constructed by the taxpayer and another fact of the regulations issued under Sections 1.46C1 and 1.48B4 is to the effect that the taxpayer is entitled to take the investment credit on its construction equipment is not entitled to take the investment credit on the facilities that it has constructed.
In other words, those regulations in effect or exactly in accordance with the position taken by the taxpayer here as to depreciation we believe are entitled to depreciation on the equipment that we used in construction and we do not include such depreciation on the basis of the facilities constructed.
Now, it is true under the investment credit regulation that there written was a certain self serving probations, in other words written in the terms if depreciation is sustained non property that should be capitalized like then it won’t be capitalized for the purpose of the investment credit but instead will not be considered to be part of basis.
Now, if that were a proper interpretation of the law to be exactly contrary to the investment credit law statute itself because the statutes requires that the investment credit be imposed on the basis of property constructed by the taxpayer and the regulations in another fact say that the basis shall not include depreciation incurred by the taxpayer on its construction equipment.
In consequence, what I am suggesting is that there has neither been a long nor a consistent history all over the Treasury Department and requiring capitalization of depreciation.
Chief Justice Warren E. Burger: Do you have anything further Mr. Jones?
Rebuttal of Keith A. Jones
Mr. Keith A. Jones: Thank you Mr. Chief Justice.
I really have very little to offer but something that closing counsel said cast Mr. Justice Powell’s question somewhat different like for me and I did want to respond to that.
We are not taking the position in this case that financial accounting is necessarily the guide to the interpretation of the tax code but we’re saying is that when taxpayers claiming a deduction which is not even permitted by financial accounting, then he really ought to show very explicitly, very clearly statutory language which permits that deductions and its our position here that no such statutory language has been shown but to the contrary, we pointed out in Section 263 explicitly bars the deduction here that is necessary impact of Sections 161 which makes the deduction for depreciation subject to the capitalization provision.
There are a number of small points in case which has been argued and I think they’re all properly answered in our brief and in our reply brief and I won’t go into them at length here with one exception which is the taxpayers argument that there is something about the cases under Sections 170 and 213 pertaining to the medical expense deduction, charitable contribution deduction which is favorable to him here.
Well, those provisions provide for deductions of amounts paid during the taxable year and the Courts have construed depreciation is not being an amount paid out during the taxable year for purposes of those deduction provisions but statute were reliant on Section 263 does not require payment during the taxable year merely requires an amount paid out at sometimes.
As we have shown, there has been an amount paid out here and it is represented by depreciation.
Justice Potter Stewart: Will this anything be true of estate and local taxes paid up on this equipment?
Mr. Keith A. Jones: The history of estate and local taxes and other caring charges such as interest is a long one.
The courts in the -- I think 20’s and 30’s perhaps the 30’s were holding that those expenses were not capital items because they did not improve the value of the taxpayers property.
The courts held it, those payments of taxes and interest were merely incurred to retain ownership of the property and for that reason were not capital.
Justice Potter Stewart: But they were -- one of the cause of ownership to the equipment that was used in the construction of the capital assets.
Mr. Keith A. Jones: That’s right and I think that the holding that those items were not capital is subject to some question.
But in our case, it is clear that the depreciation on the construction equipment was incurred in the course of improving the property and the course of creating a new capital asset and that is clearly capital and the earlier lower court decisions holding that interesting taxes weren’t properly capital which is really a holding on economic grounds whether on legal grounds I think really aren’t in point here.
Nor I as I say the case is with respect to the medical contributions and the medical deductions and the charitable contributions, the purpose of those deduction provisions is to allow a deduction, to allow some tax relief when a taxpayer incurs an expense which she wouldn’t otherwise have to incur and all the cases which the respondent sites involves the occasional use of an automobile or of an airplane, an automobile or an airplane which would have been depreciated anyway.
There was no reason in the purpose of the statute to provide a deduction or to permit a deduction that depreciation which would have been incurred anyway and therefore I think the courts properly held that it was not deductible under those provisions.
Again, those decisions it seems to us has have absolutely nothing to do with the issue in this case.
Chief Justice Warren E. Burger: Thank you gentlemen.
the case is submitted.