Rev. Rul. 67-22

Advice has been requested concerning the treatment for Federal income tax purposes of welded rail costs under the retirement and replacement method of accounting for depreciation generally used by railroads for track accounts.

In the strict sense, retirement accounting involves the capitalizing of the cost of each new asset put into use, and charging off as expense (only when retired) the original capitalized cost of the asset being retired. Likewise in the strict sense, replacement accounting involves charging the cost of assets to expense at the time they are put into use (when replacing assets) without disturbing the capital account balances. Betterments are part of replacement accounting. When a replacement involves a betterment, the betterment portion of the replacement is capitalized.

However, both the railroad industry and the Internal Revenue Service use `retirement method' to mean a method of accounting for depreciation composed of elements of retirement and replacement accounting. For assets accounted for under this `retirement method,' no ratable deduction for depreciation is claimed and no depreciation reserve is maintained. The investment in the track accounts (original track structure and additions thereto), including the labor costs, is capitalized. When any asset of the track structure is replaced in kind and quality, for example when 80-pound rail is replaced with 80-pound rail, the capital account is not disturbed. Instead, the cost of the replacement rail, less the salvage value of the recovered rail, together with labor costs for removing the old and installing the replacement is expensed.

When any asset of the track structure is replaced with a betterment, for example, 100-pound rail for 80-pound rail, the cost of the 20-pound betterment portion is capitalized and the cost of the 80-pound replacement portion, less the salvage value of the recovered rail, together with all labor costs incurred is charged to expense.

When any asset of the track structure is retired without replacement, a credit is made to the capital account for the capitalized book cost of the retired asset and that amount (less salvage value) together with labor costs of removal is charged to expense.

Since replacements and their labor costs have been expensed, the capital accounts reflect only the original investment (and additions thereto), including their labor costs, plus subsequent betterments, if any. Thus, in theory, under this `retirement method' of accounting for depreciation, the balance in the track structure capital accounts represent the adjusted basis of the assets reflected in such accounts.

The use of this method of accounting for depreciation permits a railroad to take, as a rough equivalent of depreciation on all remaining assets in the track accounts, a deduction in an amount aggregating: (1) the cost of replacements in kind and quality less the salvage value of the materials recovered; (2) the cost of the uncapitalized portion of replacements where betterments are involved, less the salvage value of the materials recovered; (3) the capitalized cost of retirements without replacements, less the salvage value of the materials recovered, and (4) the labor costs incurred in retirements and replacements.

For many years it was the practice of railroads to purchase rails in lengths of 39 feet, or shorter, and bolt them together with joint or angle bars. In more recent years, however, welded rails have come into use. Today the practice is to weld together rails of varying lengths which eliminates the necessity for using joint or angle bars. The welding process reduces track renewal costs, prolongs the life of the rail and rolling stock, and substantially reduces maintenance and overhead costs.

Some railroads expense all rail-welding costs apparently on the theory that since welding adds neither material nor weight to the rails, there is neither an improvement nor a betterment to be capitalized.

Section 263 of the Code provides, in pertinent part, as follows:

(a) GENERAL RULE.-No deduction shall be allowed for-

(1) Any amount paid out * * * for permanent improvements or betterments made to increase the value of any property or estate * * *.

The welding of rail creates something new or better by substitution or addition of different materials, reduces track renewal costs, prolongs rail and rolling stock life, reduces maintenance costs, and increases the value of the track structure. See Rev. Rul. 60-386, C.B. 1960-2, 107.

Accordingly, under the `retirement method' of accounting for depreciation composed of elements of retirement and replacement accounting, initial welding costs are to be capitalized since a permanent improvement or betterment has been effected. However, under this method where welded rail is replaced with welded rail of the same kind and quality, no further betterment is involved and the rail replacement and labor costs, less the salvage value of the recovered rail, are properly charged to expense. Also, where joint or angle bars are retired because welding has occurred, the unrecovered capitalized costs (including the original labor cost of installation) of the joint or angle bars, less their salvage value, are properly charged to expense.