
    THE KANSAS CITY SOUTHERN RAILWAY COMPANY AND LOUISIANA & ARKANSAS RAILWAY COMPANY v. THE UNITED STATES
    [No. 49883.
    Decided June 2, 1953.]
    
      
      Mr. Dean P. Kimball for the plaintiffs. Mr. J os. R. Brown and Covington Burling were on the briefs.
    
      Mr. J. W. Hussey, with whom was Mr. Assistant Attorney General H. Brian Holland, for the defendant. Mr. Andrew D. Sharpe was on the brief.
   Madden, Judge,

delivered the opinion of the court:

The Louisiana & Arkansas Railway Company is a wholly owned subsidiary of the Kansas City Southern Railway Company. The latter company therefore included the income of the former in a consolidated income tax return which it filed for its affiliated group for the year 1940. It and the subsidiary here seek to recover some of the taxes paid with that return, and which were attributable to the income of the subsidiary. The basis for the claim is that an expenditure in 1940 of the Louisiana & Arkansas Railway Company should have been but was not taken as a deduction in the tax return for that year. That company spent $116,548.77 for driving poles in its road bed to correct the effects of water pockets. If this work was in the nature of repairs and maintenance, its cost was deductible and the plaintiffs are entitled to recover. If it was in the nature of a capital improvement, they are not so entitled.

Water pockets developed from time to time in the sub-grade of the railroad track at various locations. The ballast, the gravel or crushed stone bed in which the ties lie, is, of course, pervious to rain water. If the nature of the soil is such that the water becomes trapped in the subgrade, the subgrade becomes and remains soft and yielding, and the pressure of trains upon the ties and ballast depresses them and makes the operation of trains over the tracks at economical speeds dangerous.

The pole-driving method of attack upon the water pocket problem consists of driving wooden poles vertically into the ground at the ends of the ties. The poles are driven four or more feet below the bottom of the water pocket, hence their length depends on the vertical location and depth of the pocket. The poles are about six inches in diameter and are set at intervals of about eighteen inches. They are driven with a drop hammer. The pole-driving process solves the water pocket problem satisfactorily, and is the least expensive of three known methods of solving it. It is thought that when a water pocket is so treated, the beneficial effects will continue for some fifteen years.

Our problem is to determine whether the pole-driving work was maintenance work' or capital improvement work. If, at the time of the original construction of the railroad, it had been possible to foresee where the water pockets would appear, and the poles had then been driven, their cost would, of course, have been a capital cost. But the water pockets develop and appear casually, and, as they appear, they present a problem of maintaining an existing completed track in a safe and economical operating condition. If in particular locations it should be found that ordinary railroad ties were subject to extraordinary deterioration because of soil conditions or insects, and the ties were replaced with others of a type which would withstand these attacks better and longer, that replacement would, we think, be maintenance. The fact that the replacements, once made, would be good for many years, would not seem to be significant. When a building or a machine is repaired, it is not unusual that the repaired portion is better than and will outlast the parts that have not yet needed repairs. In the instant case the railroad track, after the poles were driven, was still just a railroad track, and the parts of it where the poles were driven were no more useful than the other parts which had not needed this work.

As shown in finding 16, the Bureau of Accounts of the Interstate Commerce Commission issued a ruling which seems to be in accord with the view which we take. The Board of Tax Appeals, now the Tax Court, in Appeal of Illinois Merchants Trust Company, 4 B. T. A. 103, and the Court of Appeals for the Sixth Circuit in American Bemberg Corporation v. Commissioner, 177 F. 2d 200, affirming 10 T. C. 361, made decisions which seem to us to support the view we take. The memorandum decision of the Tax Court in Texas c& Pacific Railway Co. v. Commissioner, 1 T. C. M. 863, 1943 P-H T. C. Memorandum Decisions, par. 43165, seems to us to be less persuasive than the other decisions cited above.

The plaintiff is entitled to recover $27,971.70 with interest as provided by law.

It is so ordered.

Howell, Judge; Whitaker, Judge; Littleton, Jud.ge; and Jones, Chief Judge, concur.

FINDINGS OF FACT

The court, having considered the evidence, the report of Commissioner William E. Day, and the briefs and argument of counsel, makes findings of fact as follows:

1. The Kansas City Southern Bailway Company was at all times material herein a Missouri corporation operating approximately 900 miles of railroad in Missouri, Kansas, Oklahoma, Arkansas, Louisiana and Texas. Its principal place of business is at 114 West 11th Street, Kansas City, Missouri.

2. The Louisiana & Arkansas Eailway Company, a Delaware corporation, at all times since 1939 has been a wholly-owned subsidiary of The Kansas City Southern Kailway Company, operating approximately 800 miles of railroad in Louisiana, Texas and Arkansas. Its principal place of business is at 114 West 11th Street, Kansas City, Missouri.

3. On April 15,1941, pursuant to extensions granted, The Kansas City Southern Bailway Company and its affiliated companies filed a consolidated income, declared value and defense tax return for the calendar year 1940. The return reported, on the accrual basis, taxes due of $179,468.76, which taxes were paid by The Kansas City Southern Eailway Company in quarterly installments during 1941. On the face of the first page of such return the taxpayer included a notation as follows:

In accordance with paragraph 1 of Instructions for Form 1120, statements of net income and profit and loss in form required by the Interstate Commerce Commission, are filed herewith.

4. In computing consolidated net income for 1940, no deduction was taken on the return filed for that year for the amount of $116,548.77, paid by the Louisiana & Arkansas Eailway Company in that year for driving poles in its roadbed in order to correct the effects of water pockets and mud-heaves therein.

5. Claims for refund of income taxes in the amount of $27,971.70 for 1940 were filed on September 24, 1943, and August 30, 1948, based upon the following allegations:

During the calendar year 1940, Louisiana & Arkansas Eailway Company, a member of the affiliated group, expended the sum of $116,548.77 as cost of driving poles in road bed for purpose of curing water pockets and mud heaves. This expense was currently charged to capital investment, whereas it should have been charged to roadway maintenance as a business expense deductible for income tax purposes. Book accounting has been revised accordingly with the result that taxable income for the year 1940 has been overstated in the amount claimed herein.

6. On November 10, 1948, the Deputy Commissioner of Internal Eevenue notified the plaintiffs by registered mail that their claim for refund of $27,971.70 in income taxes for the year 1940 was disallowed in full.

7. During the taxable year 1940, the Louisiana & Arkansas Eailway Company paid $116,548.77 on account of pole-driving expenses. This amount was reasonable for the work performed. Of the foregoing figure, approximately $40,-000 was expended as the cost of poles, $48,000 was the amount paid to an independent contractor for the driving of the poles, and the balance was for labor and other costs to the railroad incidental to the work.

8. The purpose of pole-driving was to remedy the difficulty that the company was having with unsafe track which was caused by water pockets.

9. Water pockets developed in certain locations of the Louisiana & Arkansas Railway Company trackage from time to time in the subgrade that supports the track structure. This subgrade lies beneath the ballast, and the water pockets are the result of rain water draining through the ballast and being entrapped in small depressions in the earthen sub-grade. Where the subgrade has become foul because of the clay content, the entrapped water cannot escape or drain away, and the train movement over the rails drives the ballast deeper into the subgrade and causes mudheaves.

10. The effect of mudheaves is to make the track foundation unstable and to prevent economic maintenance of the lines in service. Mudheaves also frequently result in unsafe track for operation of trains at the regular timecard speed.

11. The pole-driving method of combating the adverse effect of the formation of water pockets consists of driving poles approximately six inches in diameter and from eight to fourteen feet in length down into the ground at right angles to both ends of the ties. The poles are driven in place with a machine that has leads and a drop hammer, and they are driven at about eighteen-inch intervals and four or more feet below the bottom of the water pockets. This method has been found very satisfactory and is the least expensive of three possible methods.

12. Prior to 1939, the company used another method of combating the adverse effects of water pockets, which consisted of digging out the old roadbed and replacing it. Under that method the track was shifted to one side of the embankment, permitting train operation and also removal of the materials in the subgrade. This material is removed to a point below the bottom of the water pockets after which it is replaced with new dirt, and this replaces the water pockets. The track is then lined back to its original position and reballasted. This method is a very expensive one. When the company used this earlier method, it did not capitalize the costs on its books.

13. In 1940, 387,078 poles were driven in a total trackage of 55 miles of the Louisiana & Arkansas Railway Company in remedying the situation caused by water pockets along such trackage. Expenses in connection with the driving of poles were incurred by this company in 1939 as well as in 1941,1942 and 1943, along other portions of its tracks from those which were repaired in 1940.

14. The effect upon the railroad trackage of the driving of poles referred to above is to partially restore the stability of the roadbed, which stability had been either damaged or threatened by water pockets or mudheaves. Engineers estimate that the benefits derived from such pole driving continue for approximately fifteen years.

15. In 1942, as a result of a ruling in an Interstate Commerce Commission case, which came to the attention of the Chief Auditor of the railroad, the company changed its accounting method of treating the pole-driving expense. The matter was referred to the Chief Engineer for his opinion as to whether the work was considered permanent or temporary, and thereafter a conference was held between the Chief Engineer and the Chief Auditor, resulting in the charging of the cost of pole driving to maintenance rather than to capital investment.

16. On May 1,1942, a ruling was issued by the Bureau of Accounts of the Interstate Commerce Commission (Case A-168) in which it was held that the cost of stabilizing the subgrade of roadbeds due to water pockets and mudheaves should be included in the operating expense account No. 202, entitled “Roadway Maintenance,” unless the work is considered of a permanent character and, in the judgment of the engineers of the company involved, results in increasing the stability of the roadbed beyond that which existed at the time of the original construction. This ruling referred to the pole-driving method.

conclusion of law

Upon the foregoing findings of fact which are made a part of the judgment herein, the court concludes that as a matter of law the plaintiffs are entitled to recover. It is therefore adjudged and ordered that plaintiffs recover of and from the United States the sum of twenty-seven thousand nine hundred and seventy-one dollars and seventy cents ($27,971.70), with interest as provided by law.  