filed: September 9, 1992; As Corrected September 18, 1992.
On Appeal from the United States Tax Court. (T.C. No. 89-853)
Before: Greenberg, Alito, and Aldisert, Circuit Judges
GREENBERG, Circuit Judge.
Armstrong World Industries, Inc., and its affiliated companies (hereinafter referred to as "Armstrong"), appeal from a decision of the Tax Court entered on October 29, 1991, sustaining a determination of the Commissioner of Internal Revenue that Armstrong had a $5,032,135 income tax deficiency for tax year 1981 and denying Armstrong's claim of an overpayment of approximately $20 million in taxes for the same year. The deficiency resulted from the Commissioner's disallowance of depreciation deductions and investment credits claimed by Armstrong under the now repealed "safe-harbor leasing" rules of Internal Revenue Code Section 168(f)(8).*fn1 Armstrong predicated its claim for overpayment on a theory that it should have been allowed to depreciate in one year certain property it acquired in three safe-harbor leasing agreements rather than over five years as it had done.
This appeal implicates three questions: (1) whether the properties transferred in the safe-harbor transactions were "placed in service" within the required statutory time period; (2) whether one of the safe-harbor lease agreements was invalid because it did not contain an identification of the subject properties on the date of its execution; and (3) whether the treasury regulations, which prohibited safe-harbor lessors from using a transitional depreciation rule found in Section 168(f)(3), conflicted with the plain language of the Code. The Tax Court concluded that the majority of the transferred properties were not placed in service during the necessary period, the incomplete safe-harbor leasing agreement was invalid, and Armstrong was not entitled to invoke the special transitional rule of Section 168(f)(3). For the reasons that follow, we will affirm.
In broad terms, the safe-harbor leasing rules established in Section 168(f)(8) permitted one taxpayer to sell certain of its tax benefits to another. The tax benefit transfer could be accomplished through a fictional sale and leaseback of "qualified leased property." The agreement would be respected as a true transaction for tax purposes only, and thus the buyer-lessor, as the new "owner" of the property, would become entitled to the associated tax benefits. "Qualified leased property" under the Code was property that, inter alia, was leased within three months after the date it was "placed in service." Section 168(f)(8)(D)(ii).
In December 1981, Armstrong entered into nine safe-harbor leasing agreements purchasing a number of railroad properties from Consolidated Rail Corporation ("Conrail"). Therefore, Armstrong's 1981 income tax return included depreciation deductions and investment tax credits reflecting these transactions. However, the Commissioner did not completely accept Armstrong's returns and sent Armstrong a timely notice of deficiency stating that it had failed to establish that three of the agreements satisfied the requirements of Section 168(f)(8). Armstrong petitioned the Tax Court for a review of the Commissioner's determination, but the court agreed that the three agreements did not comply with Section 168(f)(8), for it found in a detailed opinion that some of the included properties had not been placed in service within the three months prior to the date of the agreements and that one of the three agreements did not identify the subject properties on the execution date. 62 T.C.M. (CCH) 148 (1991).
The second aspect to the controversy involves Armstrong's claim for a tax refund of approximately $20 million for 1981 predicated on its assertion that it was entitled to a deduction in that year of the entire cost of certain track replacement property acquired from Conrail in another three of the nine safe-harbor lease agreements. The Tax Court denied this claim, finding that Armstrong had properly depreciated the track replacement property over a five-year period beginning in 1981 and that the applicable treasury regulations precluded safe-harbor lessors from electing the benefit of Section 168(f)(3)'s special one-year recovery period for such property. The court upheld the regulations over Armstrong's argument that they were contrary to the plain language of the Code or were otherwise arbitrary, capricious or contrary to law.*fn2 Armstrong filed a timely notice of appeal on January 21, 1992, see 26 U.S.C. § 7483,*fn3 and we have jurisdiction pursuant to 26 U.S.C. § 7482(a).
B. The Conrail-Armstrong Safe-Harbor Leasing Agreements
The Tax Court's findings of historical fact are, with one exception, undisputed. In December 1981, Armstrong entered into nine agreements with Conrail, whereby Armstrong agreed to purchase railroad properties with a $96 million total basis and to lease them back to Conrail pursuant to the safe-harbor leasing rules.*fn4 The agreements, only six of which are involved in this dispute, were either dated "as of December 17, 1981" or "as of December 31, 1981." Of those six, three transferred additions and improvements to Conrail's physical plant (the "A &I agreements"), and three transferred track replacement structures. Although the agreements provided for Armstrong to make payments of principal and interest to Conrail, and for Conrail to make rental payments to Armstrong, those payments were not made. Rather, in return for the tax benefits, Armstrong made wire transfer payments to Conrail on December 17 and 31, 1981, in the respective amounts of $19,006,523.86 and $15,738,726.14.
1. Properties Subject to the A &I Safe-Harbor Leasing Agreements
Each of the three A &I leasing agreements covered an assortment of properties culled from the four Conrail projects we discuss below as well as from other projects not relevant here. For example, the $16,500,000 A &I agreement*fn5 transferred properties from the Olean, Oak Island, and Allentown projects. In order to satisfy the safe-harbor provisions of the Code, the transferred property must have been "placed in service" within the three-month period prior to the date of the tax benefit transfer transaction. Under Temp. Treas. Reg. § 5C.168(f)(8)-6(b)(2) property was "placed in service" when "placed in a condition or state of readiness and availability for a specifically assigned function." Thus, properties included in the December 17, 1981 A & I agreement should have been placed in service no earlier than September 16, 1981, and properties included in the December 31, 1981 A & I agreements should have been placed in service no earlier than September 30, 1981.*fn6 We will summarize the Tax Court's findings relevant to the determination of the placed in service dates. 62 T.C.M. (CCH) at 150-154.
a. The Orrville to Colsan Traffic Control System
In the late 1970's, Conrail experienced congestion and delays in the movement of trains on the Pittsburgh to Chicago main rail line between Orrville and Colsan, Ohio. This line consisted of 76 miles of two parallel tracks on each of which trains could be operated in only one direction. The various interlockings*fn7 along the route were controlled by human operators stationed in towers. The operators watched for oncoming trains, flashed the appropriate signals to them, and manipulated the interlockings to ensure that each train was routed onto the appropriate track or siding. The instructions for aligning the track for each train were given to each operator verbally by another dispatcher at a distant location.
On April 12, 1977, Conrail's board of directors approved construction of a $12.9 million traffic control system ("TCS") to eliminate delays between Colsan and Orrville by permitting two-way movement of trains on each of the parallel tracks. The TCS was to be governed by a computer in Youngstown, Ohio, which would allow an operator to control the trains and track switches by remote control, and would generally eliminate the need for human operators stationed along the line. In addition, once the entire TCS was completed, the computer would be able to prioritize the movement of trains along the track. The computer was installed and began operation in 1980.
The TCS was constructed in 11 geographic segments. When new signals, track work, and computer wiring were completed in a segment, the segment was "cut over," i.e., turned over by construction personnel to local crews for actual train operation. Each completed segment was then permanently connected to previously completed segments and temporary wiring to unreconstructed segments was installed. The newly completed segment was remotely controlled from Youngstown.
Ten of the 11 segments of the Orrville to Colsan TCS were cut over to local train crews for actual train operation prior to September 1981 -- the first segment in March 1979, and the tenth in May 1981. The 11th segment was cut over on October 26, 1981.
ii. The Tax Court's Findings
Although Conrail considered the entire project to be placed in service on the date that the last segment was cut over and the computer could prioritize the train traffic, the court determined that, because each segment became fully functional in the intended manner when it was cut over, the segments were placed in service on their respective cut over dates. Therefore, the court held that only the 11th segment had been placed in service within the three-month window. However, the court also recognized that, although the computer system had the capacity to throw switches and change signals by remote control, it could not make prioritizing decisions along the entire route until the final segment had been cut over. Thus, the court treated the computer as a separate project placed in service within the three-month window.*fn8
b. The Allentown Yard Project
Prior to 1978, Conrail owned two deteriorated "hump" rail classification yards in Allentown, Pennsylvania. A rail classification yard receives incoming trains, re-sorts the cars into new outgoing trains, and sends new trains out of the yard. In a "hump yard," trains are uncoupled at the crest of an artificial hump or hill, and the cars are then routed onto the appropriate track as they descend into the yard. Each car as descending is braked by retarders built into the track.
On June 13, 1978, Conrail's board of directors approved a $13 million project to eliminate one of the Allentown yards and expand the other. One component of the project, an automated hump control system, was installed by SAB Harmon Industries, Inc. ("Harmon"). The hump control system was first tested and put into operation in January 1981. The system, however, had several problems which Harmon corrected.
In November 1981, Harmon personnel made two hardware and software changes to the hump control system -- one to enable relays to operate fewer times, making the retarders close fewer times, and another to compensate for the temperature so that the cars would be released more quickly in cold weather and more slowly in hot weather. The changes were "enhancements" to the design of the system and were not part of the original specifications. After November 1981, the system underwent only routine maintenance.
ii. The Tax Court's Findings
In order to fix the placed in service date within the three-month window, Armstrong argued, and maintains on appeal, that "the expedited train movements originally intended by Conrail were possible only when the hump controls were corrected in November, 1981," and therefore that the entire project was placed in service in that month. However, the Tax Court found that the November changes were enhancements -- design changes not in the original specifications -- and that the originally intended function had been attained, and the project placed in service, in January 1981.
c. The Oak Island Yard Project
In January 1980, Conrail's board of directors approved a $10.6 million project to replace the three pre-existing rail classification yards in the area of Oak Island, New Jersey, with a single, modernized yard. The new yard project included a hump control system nearly identical to the one in the Allentown yard. Harmon installed the system in July 1981, corrected operational problems, and completed its hardware and software modifications by September 10, 1981. Although Harmon made a further adjustment in November 1981, the parties dispute its significance.
ii. The Factual Dispute and the Tax Court's Findings
The only dispute of historical fact in this case involves an adjustment to the Oak Island computer system made by Harmon employees in November 1981. Although the Tax Court found that the adjustment merely eliminated a paper jam in the console typewriter or printer, Armstrong argues that the problem was much more serious. It contends that the paper jam was caused by a software defect which at times forced the entire hump control system to shut down. It therefore argues that the project should have been deemed placed in service only after that adjustment. The Tax Court, however, found that the "adjustment did not affect the specific function of the unit." 62 T.C.M. (CCH) at 161. The court also found that the yard itself was operated during the course of construction and that portions of the yard were used both before and after the construction work. The court therefore determined that the entire Oak Island project had been placed in service on September 10, 1981, a date just outside the three-month window.
d. The Olean Yard Project
In 1979 and 1981, Conrail's board of directors approved an $11 million project to construct, inter alia, a new rail classification yard in Olean, New York, near two major rail lines, and to install a traffic control system on a 20-mile stretch of track adjacent to the yard. Previously, a train using the Olean yard would enter or leave the yard with the help of railroad employees manually operating hand switches. Automation of those switches was essential to the operation of the new Olean yard.
Construction of the new yard was completed in 1980, and the TCS was completed and cut over in four geographic track segments. Two segments were cut over prior to May 1981, a third, between West Olean and Olean, was cut over on December 17, 1981, and the last segment was cut over in March 1982.
In addition, certain Conrail employees testified that automation of the switches and signals connecting the yard with the two main lines occurred in December 1981, at or near the time of the completion of the West Olean-Olean segment. Thus, until that time, trains still entered the yard by manual switches.
ii. The Tax Court's Findings
The Tax Court viewed the project as having five separate and independent components: the yard, and the four track segments. Because the yard was completed in 1980, and three of the four TCS segments were cut over outside of the three-month window, the Tax Court determined that only the West Olean-Olean segment had been placed in service during the appropriate time period. The court did not discuss the testimony concerning the date that remote-controlled entry into the new yard became possible, but it may have considered that function as an element of the West Olean-Olean component. However, Conrail contends that the entire project was placed in service in December, when the entrance from the major rail lines into the new yard was automated.
2. The $16,500,000 A &I Agreement
The Tax Court also found that the $16,500,000 A &I leasing agreement, which covered a selection of properties from the Oak Island, Allentown, and Olean projects, was not enforceable in 1981.*fn9 This finding provides the court's sole basis for disallowing the tax benefits related to the West Olean-Olean track segment, which the court found had been placed in service within the three-month window.
The $16,500,000 agreement, like all of the Armstrong-Conrail A&I leasing agreements, consisted of three documents: the main agreement, which contained the substantive provisions and noted the total value of the bases of the subject properties; an "Exhibit A," which described the subject properties as "all of the Additions and Improvements in respect of the property described in the Supplement to this Exhibit"; and the supplement to Exhibit A, which actually identified the properties. However, the supplement to Exhibit A of the ...