Appeals from the Decision of the United States Board of Tax Appeals.
Before WOOLLEY and DAVIS, Circuit Judges, and MORRIS, District Judge.
These cases are here on appeal from the United States Board of Tax Appeals. Separate petitions were originally filed in the cases, but they were later consolidated before the Board because substantially the same question was involved in both, which is whether or not the amounts claimed as deductions were capital expenditures and so ratably deductible over the period of the life of the lease and buildings, or were necessary expenses incurred during the taxable year in carrying on the business and allowable as deductions for that year under section 234(a) (1) and (7) of the Revenue Act of 1918 (40 Stat. 1077), which provides that in computing the net income of a corporation subject to the tax imposed by section 230 (40 Stat. 1075) there shall be allowed as deductions:
"(1) All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered, and including rentals or other payments required to be made as a condition to the continued use or possession of property to which the corporation has not taken or is not taking title, or in which it has no equity; * * *
"(7) A reasonable allowance for the exhaustion, wear and tear of property used in the trade or business, including a reasonable allowance for obsolescence;"
Section 235 of that act (40 Stat. 1080) provides that in computing net income no deductions shall in any case be allowed in respect of any items specified in section 215 (40 Stat. 1069), which provides that in computing net income, no deduction shall in any case be allowed in respect of: "(b) Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate."
Article 109 on rentals, of Treasury Regulations 45 (1920 Ed.), provides that the cost borne by a lessee in creating buildings or making permanent improvements on ground of which he is lessee is held to be a capital investment and not deductible as a business expense. In such case in order to return to such taxpayer his investment of capital, an annual deduction may be made from gross income of any amount equal to the total cost of such improvement divided by the number of years remaining of the term of lease.
It plainly appears, therefore, that if the expenditures made in these cases were capital expenditures or permanent improvements or betterments within the meaning of the act, they were not deductible for the year in which made and the orders of redetermination of the Board should be affirmed.
The Frank & Seder Company conducted a department store on the premises located at 1033 Market street, Philadelphia, under a lease which expired December 31, 1918. On February 13, 1917, a new lease was made to the company for a term of nine years from January 1, 1919. Under this lease, the company could not make any alterations to the property without first obtaining the consent in writing of the lessor. If the company did obtain consent and made alterations, it had to restore the property to its original condition or leave them as made, at the option of the lessor. Permission was given the company to remove the east wall of the premises upon giving a bond of $5,000 conditioned for the restoration of the wall at the expiration of the term. The amount of the bond was the estimated cost of the restoration.
On August 16, 1918, the parties canceled the old lease and supplemental agreement and entered into a new one which ran for nineteen years form January 1, 1919, and contained the same provisions as to alterations as the old one did. On the same date they made a new supplemental agreement which gave the company permission to break through, tear down, or remove the north wall in the rear of the property at 1033 Market street and also the east wall thereof. This enabled the company to operate this property in connection with one in the rear fronting on North Eleventh street as a single department store. In lieu of restoring the walls and putting the properties in their original condition at the expiration of the lease, the company agreed to pay the lessor $25,000; $5,000 on the execution of the lease and $20,000 on February 1, 1919, with the privilege, however, of paying the $20,000 in two payments, $10,000 on February 1, 1919, and the other $10,000 on May 1, 1919. It was estimated that it would cost $20,000 to restore the north or rear wall and $5,000 to restore the east wall. The company paid $5,000 on August 16, 1918, removed the walls before January 31, 1919, and paid the $20,000, one half on February 1, 1919, and the other half on May 1, 1919.
The cost of making the alterations which rendered the buildings suitable for the company's business purposes as distinguished from the obligation to restore the property to its original condition was charged as a capital expenditure upon the company's books, but the $25,000 paid for the privilege of making the alterations and obligation to restore the walls was charged to the expense account of carrying on the business for that year. The company kept its books on the accrual basis and contends that this fixed and definite liability, incurred in the fiscal year ended January 31, 1919, is an expense deductible from income for that year and not a capital expenditure to be prorated over the life of the lease as contended by the Commissioner. There is no dispute as to the facts, but only as to the conclusion to be drawn from them.
In Office Decision 516 Cum. Bull. No. 2, p. 112, it was held that a lessee may prorate the cost of making alterations and improvements over the life of the lease and claim a suitable deduction each year therefor, but the expenses of restoring the property at the expiration of the lease will be an allowable deduction "for the year in which it is actually incurred." In the case at bar, instead of restoring the property to its original condition at the end of the lease, the company incurred and discharged the obligation to do so in the fiscal year ended January 31, 1919. The Board of Tax Appeals held to the same effect in the cases of William J. Ostheimer, 1 B.T.A. 18; Denholm & McKay Co., 2 B.T.A. 444. The Board treated this payment as advanced rent, "since the amount paid was part of the consideration flowing from the lessees to the lessors under the lease, and the recovery of said amount by the petitioner would necessarily have to be put out of the profits which it anticipated it would make from its business, during the life of the lease." As above stated, section 234(a) (1) of the Revenue Act of 1918 provides that there shall be allowed as deductions "all the ordinary and necessary expenses paid or incurred during the taxable year * * * including rentals or other payments required to be made as a condition to the continued use or possession of property to which the corporation has not taken or is not taking title." In the case of Duffy v. Central Railroad of New Jersey, 268 U.S. 55, 45 S. Ct. 429, 431, 69 L. Ed. 846, the Supreme Court said: "The term 'rentals,' since there is nothing to indicate the contrary, must be taken in its usual and ordinary sense, that is, as implying a fixed sum, or property amounting to a fixed sum, to be paid at stated times for the use of property."
The Board defined the $25,000, the estimated cost of restoring the property, as "rent." This is not the usual and ordinary sense in which that term is used and is contrary to the meaning given to similar expenditures. It is a strained construction and not justified by the facts in the case, the language of the act, the prior regulations of the Commissioner, and decisions of the Board. O.D. 516 Cum. Bull. No. 2, p. 112; Appeal of William J. Ostheimer, 1 B.T.A. 18; Appeal of Denholm & McKay Co., 2 B.T.A. 444. This $25,000 was not "rent," but a necessary ...