Fribourg Navigation Company v. Commissioner of Internal Revenue/Opinion of the Court

by Earl Warren

United States Supreme Court

383 U.S. 272

FRIBOURG NAVIGATION COMPANY, Inc., Petitioner,  v.  COMMISSIONER OF INTERNAL REVENUE.

 Argued: Nov. 10, 1965. --- Decided: March 7, 1966

The question presented for determination is whether, as a matter of law, the sale of a depreciable asset for an amount in excess of its adjusted basis at the beginning of the year of sale bars deduction of depreciation for that year.

On December 21, 1955, the taxpayer, Fribourg Navigation Co., Inc., purchased the S. S. Joseph Feuer, a used Liberty ship, for $469,000. Prior to the acquisition, the taxpayer obtained a letter ruling from the Internal Revenue Service advising that the Service would accept straight-line depreciation of the ship over a useful economic life of three years, subject to change if warranted by subsequent experience. The letter ruling also advised that the Service would accept a salvage value on the Feuer of $5 per dead-weight ton, amounting to $54,000. Acting in accordance with the ruling the taxpayer computed allowable depreciation, and in its income tax returns for 1955 and 1956 claimed ratable depreciation deductions for the 10-day period from the date of purchase to the end of 1955 and for the full year 1956. The Internal Revenue Service audited the returns for each of these years and accepted the depreciation deductions claimed without adjustment. As a result of these depreciation deductions, the adjusted basis of the ship at the beginning of 1957 was $326,627.73.

In July of 1956, Egypt seized the Suez Canal. During the ensuing hostilities the canal became blocked by sunken vessles, thus forcing ships to take longer routes to ports otherwise reached by going through the canal. The resulting scarcity of available ships to carry cargoes caused sales prices of ships to rise sharply. In January and February of 1957, even the outmoded Liberty ships brought as much as $1,000,000 on the market. In June 1957, the taxpayer accepted an offer to sell the Feuer for $700,000. Delivery was accomplished on December 23, 1957, under modified contract terms which reduced the sale price to $695,500. Prior to the sale of the Feuer, the taxpayer adopted a plan of complete liquidation pursuant to the provisions of § 337 of the Internal Revenue Code of 1954, which it thereafter carried out within 12 months. Thus, no tax liability was incurred by the taxpayer on the capital gain from the sale of the ship. As it developed, the taxpayer's timing was impeccable-by December 1957, the shipping shortage had abated and Liberty ships were being scrapped for amounts nearly identical to the $54,000 which the taxpayer and the Service had originally predicted for salvage value.

On its 1957 income tax return, for information purposes only, the taxpayer reported a capital gain of $504,239.51 on the disposition of the ship, measured by the selling price less the adjusted basis after taking a depreciation allowance of $135,367.24 for 357 1/2 days of 1957. The taxpayer's deductions from gross income for 1957 included the depreciation taken on the Feuer. Although the Commissioner did not question the original ruling as to the useful life and salvage value of the Feuer and did not reconsider the allowance of depreciation for 1955 and 1956, he disallowed the entire depreciation deduction for 1957. His position was sustained by a single judge in the Tax Court and, with one dissent, by a panel of the Court of Appeals for the Second Circuit. 335 F.2d 15. The taxpayer and the Commissioner agreed that the question is important, that it is currently being heavily litigated, and that there is a conflict between circuit courts of appeals on this issue. Therefore, we granted certiorari. 379 U.S. 998, 85 S.Ct. 717, 13 L.Ed.2d 700. We reverse.

The Commissioner takes the position here and in a Revenue Ruling first published the day before the trial of this case in the Tax Court ^[1] that the deduction for depreciation in the year of sale of a depreciable asset is limited to the amount by which the adjusted basis of the asset at the beginning of the year exceeds the amount realized from the sale. The Commissioner argues that depreciation deductions are designed to give a taxpayer deductions equal to the 'actual net cost' of the asset to the taxpayer, and since the sale price of the Feuer exceeded the adjusted basis as of the first of the year, the use of the ship during 1957 'cost' the taxpayer 'nothing.' by tying depreciation to sale price in this manner, the Commissioner has commingled two distinct and established concepts of tax accounting depreciation of an asset through wear and tear or gradual expiration of useful life and fluctuations in the value of that asset through changes in price levels or market values.

Section 167(a) of the Internal Revenue Code of 1954 provides, in language substantially unchanged in over 50 years of revenue statutes: 'There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence)-(1) of property used in the trade or business, or (2) of property held for the production of income.' In United States v. Ludey, 274 U.S. 295, 300-301, 47 S.Ct. 608, 610, 71 L.Ed. 1054 the Court described depreciation as follows:

'The depreciation charge permitted as a deduction from the gross income in determining the taxable income of a business for any year represents the reduction, during the year, of the capital assets through wear and tear of the plant used. The amount of the allowance for depreciation is the sum which should be set aside for the taxable year, in order that, at the end of the useful life of the plant in the business, the aggregate of the sums set aside will (with the salvage value) suffice to provide an amount equal to the original cost.' See also Detroit Edison Co. v. Commissioner of Internal Revenue, 319 U.S. 98, 101, 63 S.Ct. 902, 903, 87 L.Ed. 1286. In so defining depreciation, tax law has long recognized the accounting concept that depreciation is a process of estimated allocation which does not take account of fluctuations in valuation through market appreciation. ^[2]

It is, of course, undisputed that the Commissioner may require redetermination of useful life or salvage value when it becomes apparent that either of these factors has been miscalculated. The fact of sale of an asset at an amount greater than its depreciated basis may be evidence of such a miscalculation. See Macabe Co., 42 T.C. 1105, 1115 (1964). But the fact alone of sale above adjusted basis does not establish an error in allocation. That is certainly true when, as here, the profit on sale resulted from an unexpected and shortlived, but spectacular, change in the world market.

The Commissioner contends that our decisions in Massey Motors, Inc. v. United States, 364 U.S. 92, 80 S.Ct. 1411, 4 L.Ed.2d 1592, and Hertz Corp. v. United States, 364 U.S. 122, 80 S.Ct. 1420, 4 L.Ed.2d 1603, confirm his theory. To the extent these cases are relevant here at all, they support the taxpayer's position. In Massey and Hertz we held that when a taxpayer, at the time he acquires an asset, reasonably expects he will use it for less than its full physical or economic life, he must, for purposes of computing depreciation, employ a useful life based on the period of expected use. We recognized in those cases that depreciation is based on estimates as to useful life and salvage value. Since the original estimates here were admittedly reasonable and proved to be accurate, there is no ground for disallowance of depreciation.

This concept of depreciation is reflected in the Commissioner's own regulations. The reasonable allowance provided for in § 167 is explained in Treas. Reg. § 1.167(a)-1 as 'that amount which should be set aside for the taxable year in accordance with a reasonably consistent plan * * * so that the aggregate of the amounts set aside, plus the salvage value, will, at the end of the estimated useful life of the depreciable property, equal the cost or other basis of the property * * *. The allowance shall not reflect amounts representing a mere reduction in market value.' Treas.Reg. § 1.167(a)-1(c) defines salvage value as the amount, determined at the time of acquisition, which is estimated will be realizable upon sale or when it is no longer useful in the taxpayer's trade or business. That section continues: 'Salvage value shall not be changed at any time after the determination made at the time of acquisition merely because of changes in price levels. However, if there is a redetermination of useful life * * * salvage value may be redetermined based upon facts known at the time of such redetermination of useful life.' Useful life may be redetermined 'only when the change in the useful life is significant and there is a clear and convincing basis for the redetermination.' Treas.Reg. § 1.167(a)-1(b). This carefully constructed regulatory scheme provides no basis for disallowances of depreciation when no challenge has been made to the reasonableness or accuracy of the original estimates of useful life or salvage value. Further, from 1951 until after certiorari was granted in this case, the regulations dealing with amortization in excess of depreciation contained an example expressly indicating that depreciation could be taken on a depreciable asset in the year of profitable sale of that asset. ^[3]

The Commissioner relies heavily on Treas.Reg. § 1.167(b)-0 providing that the reasonableness of a claim for depreciation shall be determined 'upon the basis of conditions known to exist at the end of the period for which the return is made.' He contends that after the sale the taxpayer 'knew' that the Feuer had 'cost' him 'nothing' in 1957. This again ignores the distinction between depreciation and gains through market appreciation. The court below admitted that the increase in the value of the ship resulted from circumstances 'normally associated with capital gain.' The intended interplay of § 167 and the capital gains provisions is clearly reflected in Treas.Reg. § 1.167(a)-8(a)(1), which provides:

'Where an asset is retired by sale at arm's length, recognition of gain or loss will be subject to the provisions of sections 1002, 1231, and other applicable provisions of law.'

The Commissioner's position represents a sudden and unwarranted volte-face from a consistent administrative and judicial practice followed prior to 1962. The taxpayer has cited a wealth of litigated cases ^[4] and several rulings ^[5] in which the Commissioner unhesitatingly allowed depreciation in the year of favorable sale. Against this array of authority, the Commissioner contends that he did not 'focus' on the issue in most of these instances. This is hardly a persuasive response to the overwhelmingly consistent display of his position. One might well speculate that the Commissioner did not 'focus' on the issue in many cases because he treated it as too well settled for consideration. Moreover, in several instances, the Commissioner did not merely consent to depreciation in the year of sale, but insisted over the taxpayer's objection that it be taken. ^[6]

The Commissioner adds that in Wier Long Leaf Lumber Co., 9 T.C. 990, rev'd on other grounds, 5 Cir., 173 F.2d 549, he did focus on the issue and there contended that no depreciation could be taken in the year of sale. However, in Wier the Tax Court allowed depreciation as to one class of assets and the Commissioner promptly acquiesced in the decision. ^[7] 1948-1 Cum.Bull. 3. This acquiescence was not withdrawn until 14 years later when the Commissioner adopted his present position. 1962-1 Cum.Bull. 5. Although we recognize that such an acquiescence does not in and of itself commit the Commissioner to this interpretation of the law, it is a significant addition to the already convincing array of authority showing the Commissioner's consistent prior position.

The Commissioner attempts further to explain away the authority aligned against him by stating that most of the cases and rulings prior to 1942 (when capital gain treatment was provided for sales above adjusted basis) are irrelevant since the gain on sale was taxed at the same ordinary income rate that would have been applied had depreciation been disallowed. This contention does not explain away the Commissioner's sudden decision that allowance of such depreciation involves a fundamental error in the basic concept of depreciation. Further, other than his lack of 'focus,' the Commissioner has had no explanation for those cases in which capital gain on sale was involved. ^[8] Even in those cases before this Court upon which the Commissioner relies for support of his theory, depreciation was willingly allowed in the year of sale. In Massey Motors, Inc. v. United States, supra, although contesting the useful life of the automobiles involved, the Commissioner allowed depreciation to an estimated value of $1,325 despite sales for an average of $1,380. 364 U.S., at 94-95, 80 S.Ct. at 1413, 4 L.Ed.2d 1592. And in Hertz Corp. v. United States, supra, the Commissioner accepted claims of depreciation deductions up to the date of sale, objecting only to the taxpayer's attempt to obtain refunds by changing retroactively to the double declining balance method of depreciation. ^[9] The fact that there are presently several hundred cases in litigation over this issue where before there were none adds testimony to the inescapable conclusion that the Commissioner has broken with consistent prior practice in espousing the novel theory he now urges upon us.

The authority relied on in Revenue Ruling 62-92, Cohn v. United States, 6 Cir. 259 F.2d 371, does not support this departure from established practice. Cohn was simply a case in which the taxpayer had assigned no salvage value to the property involved, and the Court of Appeals found no clear error in the selection of the amount realized on disposition of the asset at the end of its scheduled useful life as a reasonable yardstick by which to measure salvage value. ^[10] As has been aptly stated of Cohn, 'It does not purport to set up an automatic hindsight re-evalution which becomes a self-executing redetermination of salvage value triggered by the sale of depreciable assets.' Motorlease Corp. v. United States, D.C., 215 F.Supp. 356, 363, rev'd, 2 Cir., 334 F.2d 617, pet. for cert. filed. In his brief in Cohn, the Commissioner did not rest his case on anything resembling his position here, but relied principally on the fact that the taxpayer himself had sought an adjustment of useful life and that, under the regulations, 'if there is a redetermination of useful life, the salvage value may be redetermined.' Brief for the United States, pp. 24-26, in Cohn v. United States, 6 Cir., 259 F.2d 371, quoted in Merritt, Government briefs in Cohn refute IRS disallowance of year-of-sale depreciation, 20 J. Taxation 156, 158 (1964).

Over the same extended period of years during which the foregoing administrative and judicial precedent was accumulating, Congress repeatedly re-enacted the depreciation provision without significant change. Thus, beyond the generally understood scope of the depreciation provision itself, the Commissioner's prior long-standing and consistent administrative practice must be deemed to have received congressional approval. See, e.g., Cammarano v. United States, 358 U.S. 498, 510-511, 79 S.Ct. 524, 531-532, 3 L.Ed.2d 462; United States v. Leslie Salt Co., 350 U.S. 383, 396-397, 76 S.Ct. 416, 423-424, 100 L.Ed. 441; Helvering v. Winmill, 305 U.S. 79, 83, 59 S.Ct. 45, 46-47, 83 L.Ed. 52.

The legislative history in this area makes it abundantly clear that Congress was cognizant of the revenue possibilities in sales above depreciated cost. In 1942 Congress restored capital gain treatment to sales of depreciable assets. ^[11] The accompanying House Report stated that it would be 'an undue hardship' on taxpayers who were able to sell depreciable property at a gain over depreciated cost to treat such gain as ordinary income. H.R.Rep.No.2333, 77th Cong., 2d Sess., 54 (1942). This, of course, is pro tanto the effect of disallowing depreciation in the year of sale above adjusted basis. It would be strange indeed, especially in light of the House Report, to conlcude that Congress labored to create a tax provision which, in application to depreciable property, could by administrative fiat be made applicable only to sales of assets for amounts exceeding their basis at the beginning of the year of sale, and then only to the excess. In succeeding years Congress was repeatedly asked to enact legislation treating gains on sales of depreciated property as ordinary income; ^[12] it declined to do so until 1962.

In 1961, in his Tax Message to Congress, the President observed that existing law permitted taxpayers to depreciate assets below their market value and, upon sale, to treat the difference as capital gain. ^[13] The Secretary of the Treasury concurred in this position. ^[14] The exhibits appended not only contain no mention of the Commissioner's power to require recalculation of depreciation in the year of sale, but refute the existence of such power. In example after example cited by the Treasury, the taxpayer had depreciated an asset, sold it for an amount in excess of its depreciated basis, and treated the difference as capital gain. ^[15] The Treasury asserted that existing law permitted this practice, and made no mention of the power which the Commissioner now alleges he possesses to disallow year-of-sale depreciation.

In 1962 Congress enacted § 1245 of the Internal Revenue Code of 1954, providing that gain on future dispositions of depreciable personal property be treated as ordinary income to the extent of depreciation taken. For post-1962 transactions § 1245 applies to the situation which occurred in the instant case and would produce greater revenue. The taxpayer must report as ordinary income all depreciation recouped on sale, and this notwithstanding that the sale was part of a nonrecognition liquidation within § 337. In 1964, a more complex recapture provision dealing with real property was enacted. This time, however, Congress took into account the fact that increases in the value of real property are often attributable to a rise in the general price level and limited recapture of depreciation as ordinary income to a percentage of the excess over straight-line depreciation. H.R.Rep.No.749, 88th Cong., 1st Sess., 101-102 (1963); S.Rep.No.830, 88th Cong., 2d Sess., 132-133 (1964). ^[16] The Commissioner's position would ignore any such limitation. Compounding congressional activity in this area with repeated re-enactment of the depreciation provision in the face of the prior consistent administrative practice, we find the Commissioner's position untenable.

Finally, the Commissioner's position contains inconsistencies. He contends that depreciation must be disallowed in 1957 since the amount received on sale shows that the use of the asset 'cost' the taxpayer 'nothing' in that year. But under this view, since the asset was sold at an amount greater than its original purchase price, it 'cost' the taxpayer 'nothing' in 1955 and 1956 as well. The Commissioner's reliance on the structure of the annual income tax reporting system does not cure the illogic of his theory. Further, the Commissioner apparently will not extend his new theory to situations where it would benefit the taxpayer. If a depreciable asset is sold for less than its adjusted basis, it would seem to follow from the Commissioner's construction that the asset has 'cost' the taxpayer an additional amount and that further depreciation should be permitted. However, Revenue Ruling 69-92 does not extend to such a case and the Commissioner had expressly refused to make it do so. ^[17]

The conclusion we have reached finds support among nearly all lower federal courts that have recently dealt with this issue. ^[18] Upon consideration en banc, the Tax Court itself has concluded that the Commissioner's position is without authorization in the statute or the regulations. ^[19]

In light of the foregoing, we conclude that the depreciation claimed by the taxpayer for 1957 was erroneously disallowed.

Reversed.

Mr. Justice WHITE, with whom Mr. Justice BLACK and Mr. Justice CLARK join, dissenting.

Notes

1. Rev. Rul. 62-92, 1962-1 Cum. Bull. 29 (originally T.I.R. 384, June 7, 1962). That Ruling provides in part:
2. See, e.g., Macabe Co., 42 T.C. 1105, 1109; Wier Long Leaf Lumber Co., 9 T.C. 990, 999, rev'd on other grounds, 5 Cir., 173 F.2d 549; Note, 50 Va.L.Rev. 1431 (1964); Comment, 11 U.C.L.A.L.Rev. 593 (1964). See also Montgomery's Auditing 268 (8th ed. 1957).
3. Treas. Reg. § 1.1238-1, Example (1), based on H.R.Rep. No. 3124, 81st Cong., 2d Sess., 29 (1950), amended to conform to the Commissioner's present position on June 1, 1965. 1965-1 Cum. Bull. 366.
4. See, e.g., United States v. Ludey, 274 U.S. 295, 47 S.Ct. 608, 71 L.Ed. 1054 (1927); Eldorado Coal & Mining Co. v. Mager, 255 U.S. 522, 526, 41 S.Ct. 390, 65 L.Ed. 757 (1921); Beckridge Corp. v. Commissioner of Internal Revenue, 129 F.2d 318 (C.A.2d Cir. 1942); Clark Thread Co. v. Commissioner of Internal Revenue, 100 F.2d 257 (C.A.3d Cir. 1938), affirming 28 B.T.A. 1128, 1140 (1933); Kittredge v. Commissioner of Internal Revenue, 88 F.2d 632 (C.A.2d Cir. 1937); Seymour Mfg. Co. v. Burnet, 61 App.D.C. 22, 56 F.2d 494, 495-496 (1932); Hall v. United States, 43 F.Supp. 130, 131-132, 95 Ct.Cl. 539, cert. denied, 316 U.S. 664, 62 S.Ct. 944, 86 L.Ed. 1740 (1942); Herbert Simons, 19 B.T.A. 711, 712-713 (1930); Max Eichenberg, 16 B.T.A. 1368, 1370 (1929); Louis Kalb, 15 B.T.A. 865, 866 (1929); Even Realty Co., 1 B.T.A. 355, 356 (1925); H. L. Gatlin, 19 CCH Tax Ct.Mem. 131, 132 (1960); P. H. & J. M. Brown Co., 18 CCH Tax Ct.Mem. 708, 709-710 (1959).
5. G.C.M. 1597, VI-1 Cum.Bull. 71 (1927); S.M. 2112, III-2 Cum.Bull. 22(1924); A.R.R. 6930, III-1 Cum.Bull. 45 (1924); I.T. 1494, I-2 Cum.Bull. 19 (1922). See also I.T. 1158, I-1 Cum.Bull. 173 (1922).
6. In Herbert Simons, supra, note 4, the taxpayers tried without success to forgo the depreciation deduction for the year of sale since the taxes payable on the resulting increase in ordinary income would have been less than the increased amount payable under the existing capital gain provision if depreciation were taken. In several other cases the Commissioner expressly required a year-of-sale depreciation deduction, thus increasing the gain on the sale. See, e.g., Clark Thread Co. v. Commissioner of Internal Revenue, Kittredge v. Commissioner of Internal Revenue, Even Realty Co., supra, note 4.
7. The Commissioner's argument that the decision in Wier was ambiguous since the court there disallowed depreciation of another asset in the year of sale is without merit. The court carefully rested its decision disallowing depreciation of that asset on the fact that there was no evidence in the record which would permit it to ascertain reasonable salvage value. With respect to the other class of assets, the court stated:
8. See Hall v. United States, Herbert Simons, Max Eichenberg, H. L. Gatlin, P. H. & J. M. Brown Co., supra, note 4; G.C.M. 1597, VI-1 Cum.Bull. 71 (1927). See also cases cited, note 6, supra.
9. See D.C., 165 F.Supp. 261, 265, 269, and Transcript of Record in Hertz in this Court, at 13-18.
10. Note, for example, the Court's reliance on Wier Long Leaf Lumber Co., discussed in note 7, supra. 259 F.2d, at 378-379. Indeed, the opinion in Cohn clearly recognizes the established practice of depreciation which the Commissioner would have us overthrow. The Court there noted:
11. Int.Rev.Code, 1939, § 117(j), 56 Stat. 846 (now Int.Rev.Code, 1954, § 1231).
12. See, e.g., Hearings before the House Ways and Means Committee, 80th Cong., 1st Sess., on Revenue Revisions, pt. 5, p. 3756 (1948), at which the Treasury recommended that gains on sales of depreciable assets should be subject to ordinary income taxation to the extent the gains arose from accelerated depreciation; Hearings before the Senate Finance Committee, 83d Cong., 2d Sess., on H.R. 8300, pt. 3, p. 1324 (1954), at which Congress was asked by the American Institute of Accountants to enact that all gains on sales of depreciable assets be treated as ordinary income. See also Treasury Department Release A-761, February 15, 1960.
13. The President stated:
14. Id., at 40.
15. Id., at 262-267. See also Treas.Reg. § 1.1238-1, note 3, supra.
16. In 1963, with the instant case already in the courts, Congress for the first time alluded to the position now taken by the Commissioner, noting that:
17. In Engineers Limited Pipeline Co., 44 T.C. 226 (1965), the taxpayer contended that he should get a further depreciation deduction on assets which he sold for less than their depreciated basis. The Commissioner disallowed the additional deduction. See also Whitaker v. Commissioner of Internal Revenue, 5 Cir., 259 F.2d 379.
18. See United States v. § & A Co., 338 F.2d 629 (C.A.8th Cir.), affirming 218 F.Supp. 677 (D.C.D.Minn.), pet. for cert. filed; Occidental Loan Co. v. United States, 235 F.Supp. 519 (D.C.S.D.Calif.); Wyoming Builders, Inc. v. United States, 227 F.Supp. 534 (D.C.D.Wyo.); Motorlease Corp. v. United States, 215 F.Supp. 356 (D.C.D.Conn.), reversed on the authority of the decision below in the instant case, 334 F.2d 617 (C.A.2d Cir.), pet. for cert. filed; Mountain States Mixed Feed Co. v. United States, 245 F.Supp. 369 (D.C.D.Colo.). See also Kimball Gas Products Co. v. United States, CCH 63-2 U.S. Tax Cas. 9507 (D.C.W.D.Tex.). Contra, Killebrew v. United States, 234 F.Supp. 481 (D.C.E.D.Tenn.).
19. Macabe Co., 42 T.C. 1105 (1964). The attempt in Macabe to distinguish the instant case on the ground that here the taxpayer used inaccurate estimates and failed to sustain its burden of proof of market appreciation ignores the fact that the Commissioner does not contest the reasonableness of the original estimates of useful life and salvage value. See McNerney, Disallowance of Depreciation in the Year of Sale at a Gain, 20 Tax L.Rev. 615, 650 (1965).