What should be the tax treatment of the cost of taxpayer’s self-construction of a productive asset for it to use in its own business? Should there be a parallel between such activity and the tax treatment we accord imputed income?
Commissioner v. Idaho Power Co., 418 U.S. 1 (1974)
MR. JUSTICE BLACKMUN delivered the opinion of the Court.
This case presents the sole issue whether, for federal income tax purposes, a taxpayer is entitled to a deduction from gross income, under [I.R.C.] § 167(a) ... 1 ... for depreciation on equipment the taxpayer owns and uses in the construction of its own capital facilities, or whether the capitalization provision of § 263(a)(1) of the Code 2..., bars the deduction.
The taxpayer claimed the deduction, but the Commissioner ... disallowed it. The Tax Court ... upheld the Commissioner’s determination. The United States Court of Appeals for the Ninth Circuit, declining to follow a Court of Claims decision, Southern Natural Gas Co. v. United States, 412 F.2d 1222, 1264-1269 (1969), reversed. We granted certiorari in order to resolve the apparent conflict between the Court of Claims and the Court of Appeals.
... The taxpayer-respondent, Idaho Power Company, ... is a public utility engaged in the production, transmission, distribution, and sale of electric energy. The taxpayer keeps its books and files its federal income tax returns on the calendar year accrual basis. The tax years at issue are 1962 and 1963.
For many years, the taxpayer has used its own equipment and employees in the construction of improvements and additions to its capital facilities. [footnote omitted]. The major work has consisted of transmission lines, transmission switching stations, distribution lines, distribution stations, and connecting facilities.
During 1962 and 1963, the tax years in question, taxpayer owned and used in its business a wide variety of automotive transportation equipment, including passenger cars, trucks of all descriptions, power-operated equipment, and trailers. Radio communication devices were affixed to the equipment, and were used in its daily operations. The transportation equipment was used in part for operation and maintenance and in part for the construction of capital facilities having a useful life of more than one year.
... On its books, in accordance with Federal Power Commission-Idaho Public Utilities Commission prescribed methods, the taxpayer capitalized the construction-related depreciation, but, for income tax purposes, that depreciation increment was [computed on a composite life of ten years under straight-line and declining balance methods, and] claimed as a deduction under § 167(a). [footnote omitted]
Upon audit, the Commissioner ... disallowed the deduction for the construction-related depreciation. He ruled that that depreciation was a nondeductible capital expenditure to which § 263(a)(1) had application. He added the amount of the depreciation so disallowed to the taxpayer’s adjusted basis in its capital facilities, and then allowed a deduction for an appropriate amount of depreciation on the addition, computed over the useful life (30 years or more) of the property constructed. A deduction for depreciation of the transportation equipment to the extent of its use in day-to-day operation and maintenance was also allowed. The result of these adjustments was the disallowance of depreciation, as claimed by the taxpayer on its returns, in the net amounts of $140,429.75 and $96,811.95 for 1962 and 1963, respectively. This gave rise to asserted deficiencies in taxpayer’s income taxes for those two years of $73,023.47 and $50,342.21.
The Tax Court agreed with the [Commissioner.] ...
The Court of Appeals, on the other hand, perceived in the ... Code ... the presence of a liberal congressional policy toward depreciation, the underlying theory of which is that capital assets used in business should not be exhausted without provision for replacement. The court concluded that a deduction expressly enumerated in the Code, such as that for depreciation, may properly be taken, and that “no exception is made should it relate to a capital item.” Section 263(a)(1) ... was found not to be applicable, because depreciation is not an “amount paid out,” as required by that section. ...
The taxpayer asserts that its transportation equipment is used in its “trade or business,” and that depreciation thereon is therefore deductible under § 167(a)(1) ... The Commissioner concedes that § 167 may be said to have a literal application to depreciation on equipment used in capital construction, 3 but contends that the provision must be read in light of § 263(a)(1), which specifically disallows any deduction for an amount “paid out for new buildings or for permanent improvements or betterments.” He argues that § 263 takes precedence over § 167 by virtue of what he calls the “priority-ordering” terms (and what the taxpayer describes as “housekeeping” provisions) of § 161 of the Code 4 ... and that sound principles of accounting and taxation mandate the capitalization of this depreciation.
It is worth noting the various items that are not at issue here. ... There is no disagreement as to the allocation of depreciation between construction and maintenance. The issue thus comes down primarily to a question of timing, ... that is, whether the construction-related depreciation is to be amortized and deducted over the shorter life of the equipment or, instead, is to be amortized and deducted over the longer life of the capital facilities constructed.
Our primary concern is with the necessity to treat construction-related depreciation in a manner that comports with accounting and taxation realities. Over a period of time, a capital asset is consumed and, correspondingly over that period, its theoretical value and utility are thereby reduced. Depreciation is an accounting device which recognizes that the physical consumption of a capital asset is a true cost, since the asset is being depleted. 5 As the process of consumption continues, and depreciation is claimed and allowed, the asset’s adjusted income tax basis is reduced to reflect the distribution of its cost over the accounting periods affected. The Court stated in Hertz Corp. v. United States, 364 U.S. 122, 126 (1960): [T]he purpose of depreciation accounting is to allocate the expense of using an asset to the various periods which are benefited by that asset. [citations omitted]. When the asset is used to further the taxpayer’s day-to-day business operations, the periods of benefit usually correlate with the production of income. Thus, to the extent that equipment is used in such operations, a current depreciation deduction is an appropriate offset to gross income currently produced. It is clear, however, that different principles are implicated when the consumption of the asset takes place in the construction of other assets that, in the future, will produce income themselves. In this latter situation, the cost represented by depreciation does not correlate with production of current income. Rather, the cost, although certainly presently incurred, is related to the future and is appropriately allocated as part of the cost of acquiring an income-producing capital asset.
The Court of Appeals opined that the purpose of the depreciation allowance under the Code was to provide a means of cost recovery, Knoxville v. Knoxville Water Co., 212 U.S. 1, 13-14 (1909), and that this Court’s decisions, e.g., Detroit Edison Co. v. Commissioner, 319 U.S. 98, 101 (1943), endorse a theory of replacement through “a fund to restore the property.” Although tax-free replacement of a depreciating investment is one purpose of depreciation accounting, it alone does not require the result claimed by the taxpayer here. Only last Term, in United States v. Chicago, B. & Q. R. Co., 412 U.S. 401 (1973), we rejected replacement as the strict and sole purpose of depreciation:
Whatever may be the desirability of creating a depreciation reserve under these circumstances, as a matter of good business and accounting practice, the answer is ... [depreciation] reflects the cost of an existing capital asset, not the cost of a potential replacement.Id. at 415.
Even were we to look to replacement, it is the replacement of the constructed facilities, not the equipment used to build them, with which we would be concerned. If the taxpayer now were to decide not to construct any more capital facilities with its own equipment and employees, it, in theory, would have no occasion to replace its equipment to the extent that it was consumed in prior construction.
Accepted accounting practice 6 and established tax principles require the capitalization of the cost of acquiring a capital asset. In Woodward v. Commissioner, 397 U.S. 572, 575 (1970), the Court observed: “It has long been recognized, as a general matter, that costs incurred in the acquisition ... of a capital asset are to be treated as capital expenditures.” This principle has obvious application to the acquisition of a capital asset by purchase, but it has been applied, as well, to the costs incurred in a taxpayer’s construction of capital facilities. [citations omitted]. [footnote omitted]
There can be little question that other construction-related expense items, such as tools, materials, and wages paid construction workers, are to be treated as part of the cost of acquisition of a capital asset. The taxpayer does not dispute this. Of course, reasonable wages paid in the carrying on of a trade or business qualify as a deduction from gross income. § 162(a)(1) ... But when wages are paid in connection with the construction or acquisition of a capital asset, they must be capitalized, and are then entitled to be amortized over the life of the capital asset so acquired. [citations omitted].
Construction-related depreciation is not unlike expenditures for wages for construction workers. The significant fact is that the exhaustion of construction equipment does not represent the final disposition of the taxpayer’s investment in that equipment; rather, the investment in the equipment is assimilated into the cost of the capital asset constructed. Construction-related depreciation on the equipment is not an expense to the taxpayer of its day-to-day business. It is, however, appropriately recognized as a part of the taxpayer’s cost or investment in the capital asset. ... By the same token, this capitalization prevents the distortion of income that would otherwise occur if depreciation properly allocable to asset acquisition were deducted from gross income currently realized. [citations omitted].
An additional pertinent factor is that capitalization of construction-related depreciation by the taxpayer who does its own construction work maintains tax parity with the taxpayer who has its construction work done by an independent contractor. The depreciation on the contractor’s equipment incurred during the performance of the job will be an element of cost charged by the contractor for his construction services, and the entire cost, of course, must be capitalized by the taxpayer having the construction work performed. The Court of Appeals’ holding would lead to disparate treatment among taxpayers, because it would allow the firm with sufficient resources to construct its own facilities and to obtain a current deduction, whereas another firm without such resources would be required to capitalize its entire cost, including depreciation charged to it by the contractor.
[Taxpayer argued that the language of § 263(a)(1), which denies a current deduction for “new buildings or for permanent improvements or betterments,” only applies when taxpayer has “paid out” an “amount.” Depreciation, taxpayer argued, represented a decrease in value – not an “amount ... paid out.” The Court rejected this limitation on § 263's applicability. Instead, the Court accepted the IRS’s administrative construction of that phrase to mean “cost incurred.” Construction-related depreciation is such a cost.] In acquiring the transportation equipment, taxpayer “paid out” the equipment’s purchase price; depreciation is simply the means of allocating the payment over the various accounting periods affected. As the Tax Court stated in Brooks v. Commissioner, 50 T.C. at 935, “depreciation – inasmuch as it represents a using up of capital – is as much an expenditure’ as the using up of labor or other items of direct cost.”
Finally, the priority-ordering directive of § 161 – or, for that matter, ... § 261 7 – requires that the capitalization provision of § 263(a) take precedence, on the facts here, over § 167(a). Section 161 provides that deductions specified in Part VI of Subchapter B of the Income Tax Subtitle of the Code are “subject to the exceptions provided in part IX.” Part VI includes § 167, and Part IX includes § 263. The clear import of § 161 is that, with stated exceptions set forth either in § 263 itself or provided for elsewhere (as, for example, in § 404, relating to pension contributions), none of which is applicable here, an expenditure incurred in acquiring capital assets must be capitalized even when the expenditure otherwise might be deemed deductible under Part VI.
The Court of Appeals concluded, without reference to § 161, that § 263 did not apply to a deduction, such as that for depreciation of property used in a trade or business, allowed by the Code even though incurred in the construction of capital assets. [footnote omitted] We think that the court erred in espousing so absolute a rule, and it obviously overlooked the contrary direction of § 161. To the extent that reliance was placed on the congressional intent, in the evolvement of the 1954 Code, to provide for “liberalization of depreciation,” H.R. Rep. No. 1337, 83d Cong., 2d Sess., 22 (1954), that reliance is misplaced. The House Report also states that the depreciation provisions would “give the economy added stimulus and resilience without departing from realistic standards of depreciation accounting.” Id. at 24. To be sure, the 1954 Code provided for new and accelerated methods for depreciation, resulting in the greater depreciation deductions currently available. These changes, however, relate primarily to computation of depreciation. Congress certainly did not intend that provisions for accelerated depreciation should be construed as enlarging the class of depreciable assets to which § 167(a) has application or as lessening the reach of § 263(a). [citation omitted].
We hold that the equipment depreciation allocable to taxpayer’s construction of capital facilities is to be capitalized.
The judgment of the Court of Appeals is reversed.
It is so ordered.
MR. JUSTICE DOUGLAS, dissenting. [omitted].
Notes and Questions:
1. The Court noted that the net of taxpayer’s disallowed depreciation deductions were $140,429.75 and $96,811.95 for 1962 and 1963 respectively. The useful life of the items that taxpayer was constructing was three or more times as long as the useful life of the equipment it used to construct those items. This case is about the fraction of the figures noted here that taxpayer may deduct – after the item is placed in service.
Taxpayer’s books and taxpayer’s tax books
Distinguish between taxpayer’s books (“its books”) and taxpayer’s tax books (“for federal income tax purposes”). For what purposes does taxpayer keep each set of books? Do you think that they would ever be different? Why or why not?
2. Why do we allow deductions for depreciation? Is it that –
- ”capital assets used in business should not be exhausted without provision for replacement”?
- physical consumption of a capital asset reduces its value and utility and allowing a depreciation deduction is implicit recognition of this fact?
- obsolescence may reduce the usefulness of an asset, even if the asset could still function, e.g., a twenty-year old personal computer? See the Court’s fifth footnote.
- it is necessary ”to allocate the expense of using an asset to the various periods which are benefitted by that asset”?
- How does your view of depreciation apply to a case where taxpayer consumes depreciable assets in the construction of income-producing capital assets?
3. Aside from the Code’s mandate in § 1016(a)(2), why must a taxpayer reduce its adjusted basis in an asset subject to depreciation?
4. How did the Court’s treatment of depreciation in this case prevent the distortion of income?
Sections 161 and 261
How does the language of §§ 161 and 261 create an ordering rule? What deductions do §§ 262 to 280H create?
5. The case demonstrates again how important the time value of money is.
6. Why might Congress want to mismatch the timing of income and expenses and thereby distort income?