Appeals from the District Court of the United States for the Middle District of Pennsylvania; Albert L. Watson, Judge.
Before BUFFINGTON, THOMPSON, and BIGGS, Circuit Judges.
State Line & Sullivan Railroad Company, the appellant, possesses a single track railroad, wholly located in Sullivan and Bradford Counties, Pennsylvania, purchased by it in 1874, with certain lands and coal mining properties, for the sum of $1,000,000. Upon April 14, 1884, the appellant leased the railroad property, other than rolling stock and similar equipment to Pennsylvania and New York Canal Railroad Company for a period of fifty years, the lease to terminate upon April 30, 1934. The rental agreement provided for annual payments of $36,000 for the first three years and for $40,000 a year thereafter. The lease was assigned to Lehigh Valley Railroad Company upon December 1, 1888.
The suit at bar is for the recovery of Federal income taxes assessed and collected by the appellee for the years 1927, 1928 and 1929. The appellant claims that it is entitled to deduct the sum of $65,220.17 from its gross income for each of the years referred to because of the obsolescence of the railroad property. Though the appellant made no claim for obsolescence prior thereto, in March, 1931, it took the position that obsolescence was then apparent which, commencing in 1927, would cause the railroad line to become 100% obsolete upon April 30, 1934, the date of the expiration of the lease.
There is no doubt that changing economic conditions have worked disaster upon the fortunes of the appellant. Without going into great detail, we think it is sufficient to state that beginning with the year 1913 there was a substantial decline in the amount of coal produced and shipped from mines in Sullivan County. This decline was precipitous from 1926 to 1931, followed by a slight increase in production and shipment from 1932 to 1934. The population in Bradford and Sullivan Counties decreased substantially from 1900 to 1930. In 1927 a concrete highway was completed from Towanda to Dushore, connecting with a principal arterial highway following the level of the Susquehanna River, affording an easy outlet by truck for coal from this area. This highway drained traffic from the railroad.
In February, 1934, the Lehigh Valley Railroad Company made an offer to renew the lease for one year following April 30, 1934, for a rental of $20,000, subject to the provision that the situation should be re-examined by the parties from time to time in order that a basis for subsequent annual rentals, if any, might be agreed upon. This offer made was refused by the appellant which made no counter-offer. The appellant and the Lehigh Valley Railroad Company then applied to the Interstate Commerce Commission for permission to abandon operation of the railroad. The basis for abandonment proposed by the Lehigh Valley Railroad Company to the Interstate Commerce Commission was the refusal of the appellant to renew the lease. The appellant in its application for abandonment contended that it could not operate the railroad since it did not possess necessary organization, equipment or funds. The Interstate Commerce Commission rejected both applications on January 7, 1935.
In its claims for refund of taxes the appellant determined the period when its railroad properties would be 100% obsolete as the year 1934 for reasons which fall into the following three categories: (1) The Lehigh Valley Railroad Company would not renew the lease; (2) the depletion of coal deposits in the territories adjacent to the railroad and changed conditions of mining had reduced the line's freight tonnage to the vanishing point; and (3) that depression conditions in the mines along the line of the railroad would render it impossible to gain renewal of the lease upon any term whereby the railroad property could be operated without loss, and consequently the line must be abandoned.The original lease provided that the lessee should keep the railroad line in good condition. The proposed lease for a year contained similar terms, but the appellant takes the position that the proposed rental of $20,000 a year for a one year period would cause the loss, even of the salvage value, of $127,500.
The appellant instituted suit in the court below for the recovery of $11,193.63, with interest, this sum constituting the total of refunds which would be due it if obsolescence were allowed at the claimed yearly rate. Judgment was entered in favor of the appellee and against the appellant. From this judgment the appeal is taken.
The case was tried to the court without the intervention of a jury. Section 234(a)(7) of the Revenue Act of 1926, 44 Stat. 42, and Section 23(k) of the Revenue Act of 1928, 26 U.S.C.A. § 23(l), which are identical, provide:
"In computing net income there shall be allowed as deductions:
" * * * reasonable allowance for the exhaustion, wear and tear of property used in the trade or business, including a reasonable allowance for obsolescence * * * ".
In computing its taxable income therefore a corporation may deduct an allowance for depreciation, and quite apart therefrom may also make deductions for obsolescence. Obsolescence has been variously defined. In United States Cartridge Co. v. United States, 284 U.S. 511, 516, 52 S. Ct. 243, 245, 76 L. Ed. 431, Mr. Justice Butler stated: "'Obsolescence' may arise from changes in the art, shifting of business centers, loss of trade, inadequacy, supersession, prohibitory laws, and other things which, apart from physical deterioration, operate to cause plant elements or the plant as a whole to suffer diminution in value." In Burnet v. Niagara Falls Brewing Co., 282 U.S. 648, 654, 51 S. Ct. 262, 264, 75 L. Ed. 594, obsolescence was defined as: "The condition or process by which units gradually cease to be useful or profitable as a part of the property, on account of changed conditions."
Obsolescence obviously is akin to capital loss. Its allowance constitutes an anomaly since it is set up prior to its actual occurrence and at a rate per year based upon an estimated future 100% state of uselessness. When obsolescence has ...