Rev. Rul. 69-116

Advice has been requested whether certain expenditures for restoration of a taxpayer's freight-train cars may be deducted for Federal income tax purposes, under the circumstances described below.

The taxpayer, a railroad, uses the straight line method, with a single multiple asset account, to compute its annual depreciation allowance for its railroad freight-train cars. The original costs for cars, and a certain part of the regularly programmed annual expenditures incurred for the major restoration of such cars, are capitalized and charged to the account.

Under the taxpayer's program for freight-train car major restorations, cars needing such restoration are placed in its shops each year and restored to an efficient operating condition in cycles of about ten years, except for cars retired during a cycle.

For the taxable years prior to 1962, for Federal income tax purposes, the taxpayer used a life of 30 years to compute its annual depreciation allowance on its freight-train car account. Programmed costs were incurred to restore cars to efficient operating condition that had been in use for about 10 years (at the end of the first cycle), or about 20 years (at the end of the second cycle), and were deducted as an expense and not capitalized; but, if the same cars were not retired and programmed costs were incurred to restore them to an efficient operating condition when they had been in use for about 30 years or longer, such costs were capitalized.

For the taxable year 1962, the taxpayer adopted the depreciation guidelines of Revenue Procedure 62-21, C.B. 1962-2, 418, and used a guideline class life of 14 years for its property includible under Group Four, Class 9(a). Freight-train cars were properly included by the taxpayer in that guideline class at 17 years. Other property includible at various lives, together with the freight-train cars, make up the guideline class life of 14 years used by the taxpayer. The taxpayer continued, however, for Federal income tax purposes, to claim a deduction for all programmed major car restoration expenditures except those incurred near or after the end of the third cycle, as it had done in prior years when a 30-year life had been used for computing its depreciation allowance. Programmed expenditures incurred for the major restoration of the cars at the end of the first cycle did not, under the circumstances in this case, appreciably extend or prolong the life of such cars beyond 17 years.

The taxpayer's expenditures for incidental repair and maintenance of such cars (those not appreciably extending or prolonging the life of the cars) have consistently been claimed and allowed for Federal income tax purposes as current deductions for the taxable year they were incurred.

The specific question presented is, whether the programmed expenditures incurred for major restoration of the cars are deductible repair and maintenance expenses for Federal income tax purposes in the taxable year 1962, when the taxpayer used a life of 17 years for the cars, or must those expenditures that appreciably extend or prolong the life of cars beyond 17 years be capitalized or charged to the depreciation reserve account for such cars.

Section 162 of the Internal Revenue Code of 1954 provides, in part, for the deduction of all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.

Section 263(a) of the Code provides, in part, that no deduction shall be allowed for any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate, or for any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made.

Section 1.162-4 of the Income Tax Regulations states:

"The cost of incidental repairs which neither materially add to the value of the property nor appreciably prolong its life, but keep it in ordinarily efficient operating condition, may be deducted as an expense, provided the cost of acquisition or production or the gain or loss basis of the taxpayer's plant, equipment, or other property, as the case may be, is not increased by the amount of such expenditures. Repairs in the nature of replacements, to the extent that they arrest deterioration and appreciably prolong the life of the property, shall either be capitalized and depreciated in accordance with section 167 or charged against the depreciation reserve if such an account is kept."

Section 1.167(a)-1(b) of the regulations states in part:

"For the purposes of section 167 the estimated useful life of an asset is not necessarily the useful life inherent in the asset but is the period over which the asset may reasonably be expected to be useful to the taxpayer in his trade or business or in the production of his income. * * * Some of the factors to be considered in determining this period are * * * (4) the taxpayer's policy as to repairs, renewals, and replacements."

Sections 1.263(a)-1(a) and (b) of the regulations provide, in part, that no deductions shall be allowed for amounts paid for new buildings or for permanent improvements or betterments, or amounts expended in restoring property or in making good the exhaustion thereof including amounts paid or incurred to add to the value or substantially prolong the useful life of property owned by the taxpayer, such as plant or equipment.

The Answer to Question 33 in Appendix II of Revenue Procedure 62-21 states:

"The depreciation reform does not affect the classification of expenditures as capital or expense. Questions in this area must be resolved on the basis of presently established principles. The depreciation reform affects only those expenditures which are properly chargeable to capital and recoverable through depreciation deductions."

In adopting the 14-year guideline life with a life of 17 years for the cars, the taxpayer is considered to have adopted that period as the normal expected useful life of its freight-train cars and those expenditures incurred to appreciably extend or prolong the 17-year life of the cars are capital expenditures within the meaning of sections 1.162-4 and 1.263(a)-1(a) of the regulations. However, under the facts in the instant case those major programmed restoration expenditures for cars incurred at the end of the first cycle did not appreciably extend or prolong their lives beyond 17 years.

Accordingly, during its taxable year 1962 the taxpayer's programmed major restoration expenditures paid or incurred near or after the end of the second cycle for freight-train cars are not deductible as current repair and maintenance expenses, but must be capitalized or charged to the depreciation reserve account for such cars and may be recovered through depreciation deductions, since such expenditures appreciably extended or prolonged the life of its freight-train cars beyond the 17 years used for depreciation purposes. However, in the instant case, those programmed major restoration expenditures paid or incurred for freight-train cars at the end of the first cycle, during the taxable year 1962, are deductible for that year, since such expenditures did not appreciably extend or prolong their useful life beyond the 17 years used for depreciation purposes. Whether expenditures will extend or prolong the useful life of assets depends upon the facts and circumstances of the particular case, but such a determination shall be made by taking into account the useful life used in establishing the depreciation rate whether or not the rate results from the adoption of Revenue Procedure 62-21.

Compare Revenue Ruling 69-119, page 141, this Bulletin, which holds that certain expenditures to repair railroad cars are deductible under section 162 of the 1954 Code.