Earl Warren: Number 143, Commissioner of Internal Revenue, Petitioner, versus Robley H. Evans and Juliet M. Evans. Mr. Heffron.
Howard A. Heffron: Mr. Chief Justice, may it please the Court. This case and the two following cases raise common problems of construction under the Internal Revenue Codes of 1939 and 1954. The questions relate to the proper computation of the deduction allowed for depreciation in computation of the income tax. This case, Evans, comes to this Court upon the Government's petition for certiorari to the Ninth Circuit. The case which follows it, the Hertz case comes to this Court from the Third Circuit and the case which follows Hertz, the Massey Motor case from here from the Fifth Circuit. Both the Third Circuit and the Fifth Circuit reached results contrary to that of the Ninth Circuit in the Evans case; that is in support of the Government's position. The question which is common to all three cases is one which concerns the proper method of computation of the depreciation deduction permitted under the pertinent provisions of the Internal Revenue Code. Now, since the depreciation is no more than in means of describing the proportionate proportion of the cost of an asset which ought to be allowed as a deduction in computing income for any given period. We are here concerned with the proper method of allocating that cost to different taxable periods. If the asset only lasted for the one year period which is covered by an income tax return, we would have no problem. The cost of that asset would be deducted in full if it were consumed during that period. The problem arises because of the nature of the tangible assets which are the subject of these three cases. Automobiles, automobiles last more than the one year period covered by an income tax return. On the other hand, they do not last forever. At some period, they are discarded. They are retired from service and the problem presented by these three cases is how to determine what proportion of the cost of an asset which lasts more than the period covered by the income tax return, what proportion of that cost shall be allocated to the income tax year covered by any particular return? I say the problem arises because the asset itself lasts beyond the period covered by the return.
Speaker: Is the rule that you're advocating here is limited to automobiles or is it one of general application?
Howard A. Heffron: No. It would be a rule of general application. I cited automobile simply as an example of a tangible asset whose -- which lasts beyond the one year tax period normally covered by an income tax return. It could apply to heavy machinery, could apply to any type of asset used in industry or business, which would last beyond the period covered by the return. Now, if I can absolutely dispute at the outset in this fashion, I would say that the basic position for which the Government contends here is simply this that in determining the cost of the asset which ought to be allocated to the income tax period covered by the return, one ought to take into account as a relevant material in the persuasive factor, the total period of time the taxpayer expects to use the asset. Having made that computation, one must take into account that portion of the assets' value which the taxpayer will get back when he disposes of the asset. If he sells the asset, that portion which he receives upon sale proceeds represents a return of his original outlay in acquiring the asset. To that extent, he has not incurred a cost in using the asset and therefore we must exclude the proceeds he receives as a factor in computing what his cost has actually been. The taxpayer on the other hand as we understand it says, “No. You must disregard the period that the tax that the -- that we will use the asset. You must disregard the price we will receive for the asset when we dispose of it. You must disregard that despite the most compelling evidence of it, despite the past history of our business operations” and that really is a crystallization of what dispute comes down to in these three cases. Now, the question is of a major importance in the computation of income under the Internal Revenue Code because of dual aspects in which it affects taxpayers. First, depreciation is a deduction from gross income so that the larger the depreciation deduction, the less the gross income. On the other hand of course, the smaller the depreciation deduction, the greater the gross income. Of course gross income or net income on the tax returns would be taxed at what we call the ordinary income tax rates. Those which can go to a maximum of 52% in the case of corporations and of course a good deal higher than 75, 80 and past that in the case of individuals. On the other hand, the question of depreciation is important in another aspect and that is when the time comes for the taxpayer to dispose of his asset, his car, his plant, his piece of equipment, his electric motor, whatever it may be, when that time comes, he has made a sale, let us say we must determine what is the gain or the loss which he has realized upon the sale. Now, in order to do that, we must determine what the taxpayer's basis for the asset is. Basis is another way for our purposes at least here of describing the cost to the taxpayer, if he paid a thousand dollars for it that is his basis or his cost. On the other hand, when the time comes to sell it to the extent that he has taken depreciation deductions, to that extent he has already recovered tax-free his cost and so we must reduce the basis by the amount of depreciation and consequently the larger the amount of depreciation the larger the deduction from his cost and the lower the basis; on the other hand the smaller the depreciation deduction, the higher the basis. Now, this is very material because in computing the gain or loss, we match the basis with the sales proceeds so that if the taxpayer has a low basis as he would if he took large depreciation deductions, he would show larger gain upon the sale. Now, the significance of the larger gain upon the sale is simply this. Under the provisions of the code, the gain upon the sale of these assets used in a trade or business which are subject to depreciation is taxable at capital gain rates which are a maximum of 25% so that it is to a taxpayer's advantage to increase the amount of depreciation because although by increasing depreciation he lowers basis and consequently increases profits upon a sale when he ultimately disposes of the asset, he is very, very happy to pay larger -- larger tax of 25% by -- by taking the advantage of greater depreciation deductions which are worth to him 52% in the case of most corporations and perhaps more in the case of various individuals.
Speaker: And the converse of that is what makes the Government unhappy that you would like to have this carry to ordinary income tax rate.
Howard A. Heffron: And well, I would what makes us unhappy is the distortion in the matching of income and costs which the taxpayer's theory produces --
Speaker: I'm talking about the end result as between the two positions.
Howard A. Heffron: No. I would say that even if the -- there were no capital gain rate applicable upon the disposition of these assets, even if it with the same tax rate in each instance, there would still be a disproportion and a distortion in the report of the taxpayer's income and it would still be offensive to our notions of what the purpose of the depreciation deduction should serve.
Speaker: You wouldn't have such extreme economic differences as it does under the present?
Howard A. Heffron: Well, I say as a general proposition, it would not. In a case of any particular taxpayer might be of great importance to him whether he took more for depreciation in the year one or whether he took less in the year one and had different consequence in the years two or three. So that, I think we're dealing here with the fundamental concept which is not -- not determined by the difference in the tax rates. I suggest that difference merely to indicate the motivation for taxpayer, in this instance taking a position which increases the amount of depreciation although at a cost of paying a greater capital gains tax when the time comes to dispose of the asset.
Earl Warren: So, it will make no difference to you so far as your position is concerned whether he reported as -- as ordinary income or as a capital gain?
Howard A. Heffron: I would - I would say that our position would not be different if upon a sale of the asset the taxpayer would have pay an ordinary income tax upon the gain on the sale. Our position is not dependent upon the applicability of that difference in rate. Our position follows, we believe, from our view with the fundamental nature of the depreciation deduction and the -- an attempt to prevent a distortion of income over the years which the taxpayer is using the asset. Now, in the Evans' case, the case arises under the provisions of the Internal Revenue Code of 1939 and again, here, I can capsulate very simply, Evans bought cars cheaply because he was in the rental business and he could get a discount price from new car dealers. On the other hand, when he finished using them in his rental business, he could sell them on an awfully good price in the wholesale market. For example, in one of the years in issue, 1951, the difference is spread between what Evans paid for these cars when new and what he received for them when he sold them as used cars was only a $100 on the average. But Mr. Evans contends that he is entitle to deduct for deprecation that is as evidencing the cost to him of using the car in his rental business $450, four and a half times what in our view is the actual cost to him. Now the result for Mr. Evans is a very, very pleasant result. For example in 19 --
Earl Warren: He bases that $450 on what?
Howard A. Heffron: He bases that $450 depreciation on the theory that he may disregard the time he actually uses the car in his rental business. He may disregard the proceeds which he receives when he disposes of that car and computed depreciation on some other basis, a basis which I can only describe as one which envisions a hypothetical taxpayer in business who on the hypothetical conditions uses this hypothetical car for approximately on the average four years and who when he disposes of it at the end of that four-year period realizes nothing, he junks the car. Now, taking that view, four years will allow him to deduct 25% of the cost of his asset each year. Well, 25% of the average car let's say which cost $1600 is $400 in one year but Mr. Evans uses these cars on the average longer than one year. On the other hand, when he sells them on the open market, he gets back only $100 less than he paid for them. Now, it's the Government's position that you can't disregard these salient economic facts affecting Mr. Evans' business. If he uses the car for only 15 months which is what the tax court found as to sum of these cars, it may not assume he will use it for four years. There is no basis for it. On the other hand, if when he sells the cars, he recoups almost all of his cost about $100, it distorts his income to permit him to reflect on his tax return that the use of the assets for the period covered by the return is actually cost him $450 rather than the $100.
Felix Frankfurter: What's the four-year basis for depreciation derived from?
Howard A. Heffron: The four-year basis is derived from a publication of the Internal Revenue Service which is called probable useful lives and which defines the -- based upon the usual experience of property owners what the usual experience will reflect in terms of the years which an asset will be held and used by a taxpayer and it is precisely that. It is a starting point, based upon usual experience which is to be modified by the pertinent economic facts affecting the particular taxpayer's situation.
Felix Frankfurter: (Inaudible) his average is derived from the life use of car and mine? Is that it?
Howard A. Heffron: No, I would say --
Felix Frankfurter: -- or dealing cars with?
Howard A. Heffron: From -- from general business use, general businesses.
Felix Frankfurter: Business?
Howard A. Heffron: Yes. Well, as generally all businesses but even as to that for example --
Felix Frankfurter: Do you mean, passed on by -- by the paper company, that's what you mean?
Potter Stewart: And operated for example by salesman, traveling salesman?
Howard A. Heffron: Yes. Car is operated generally in business.
Felix Frankfurter: In other words, what you say an abstraction or a model; this is a tax model, is it?
Howard A. Heffron: Yes.
Felix Frankfurter: What the economists call model. This is a model to be applied to an individual although he, himself, the fact of his case do not fit the model, is that it?
Howard A. Heffron: Well, it is not to be applied in that instance.
Felix Frankfurter: Isn't that the argument that you are combating, is it?
Howard A. Heffron: Yes. I would say that the taxpayer's argument here is that they are entitled to use this model and disregard the pertinent economic facts surrounding (Inaudible) of the asset.
Hugo L. Black: Do they claim that some regulation authorizes that?
Howard A. Heffron: Well, I was coming to that. There is a -- there is a contention here that the practice authorizes that and I will come to that next in my argument.
Felix Frankfurter: Say it right away, say it right away, do you contend there is no such practice or that if there is, it's to be disregarded which, don't argue that, I just want to know it.
Howard A. Heffron: We contend there is no such practice.
Felix Frankfurter: All right.
Charles E. Whittaker: As I understand Mr. Heffron that the issue between the issue is whether or not the taxpayer is entitled to depreciate the property over its useful right as an asset or over its like -- useful life by the particular taxpayer. Is that enough if --
Howard A. Heffron: Well, I can only characterize the taxpayer's position as this that he urges he may depreciate the asset over its average general life for business purposes and that --
Charles E. Whittaker: In all business?
Howard A. Heffron: In all businesses and that he may disregard the fact that in his business, it is the practice to dispose the cars in 15 months rather than four years. He may disregard the fact that because he buys at a discount and sells in a different market that in fact he gets very, very substantially, the most part of his cost back when he disposes of the asset. The taxpayer says we can disregard that because the general experience in business for all business purposes is four years with no value at the end of that four-year period. Now, it's our position that you cannot disregard the pertinent economic facts and what could be more pertinent since this is after all an analysis into what a given asset costs a taxpayer than to determine what it is you're getting back when you finish with your use of this asset. That is a return of your cost. That should not be part of the computation. Taxpayer would disregard the fact that when he sells these cars, he gets back in the year 1951 all but a $100 of what he paid for them. We say it only has a $100 to depreciate.
Speaker: Could I ask you one question? Assuming the model as Mr. Justice Frankfurter referred to it, applied, is there any -- is there any dispute between you and the taxpayer as to whether the right model was used? In other words, this four-year of useful life that's used by the taxpayer is the proper criteria? Is there -- You contend that it should have been five years independently as the argument you're making?
Howard A. Heffron: No, no. The model is --
Speaker: -- the model is all right.
Howard A. Heffron: The model is four years.
Speaker: If it's -- if it's applicable?
Potter Stewart: It's four years for automobiles and five years for trucks, isn't it?
Howard A. Heffron: Yes. The model -- the model is -- is proper but I must emphasize again, the model is only a starting point. It's a jumping off the point. It's just a place where you begin the inquiry. You start with four years and you modify up or down, depending upon the particular facts and circumstances concerning the taxpayer's business.
Hugo L. Black: May I ask you how it works out practically because I don't quite understand, they claim an arbitrary right to take off on four-year basis. You say they don't have that. So the dispute comes up as the dispute have to come up between each individual taxpayer and the Government at the time they make their return, are they required to show that they do not come within the model or so-called or does the examiner look into it after they file their returns? How do they come to (Inaudible)?
Howard A. Heffron: The -- the purpose of this -- this Bulletin “F” which is a list of models contains literally thousand of items and lists like periods.
Felix Frankfurter: What is it called?
Howard A. Heffron: Bulletin “F”.
William O. Douglas: Bulletin “F”.
Howard A. Heffron: Yes. It is table of useful lives of depreciable property and it contains literally thousands of items and gives model average years. Now the purpose of that publication was to remove as much of this questions of useful life from the area of controversy as possible. If a taxpayer use the life period which was set forth in that model and contended that he was within the general run of the mill type of business operation and that they were no unusual circumstances concerning his method of operation which warranted a different result why then the number of years set forth in the publication could govern and a controversy would be eliminated. On the other hand, if it would come to the attention of the agent or the taxpayer that there were particular facts and circumstances concerning his operation which warranted a different result, at that point in the examination of the return, the taxpayer would show by such basis as he could why he thought a different period was warranted. For example, suppose the taxpayer contended that because of the climate in which his cars were operating, four years was too long. Perhaps he operated in a dessert and he contended that dessert conditions are such that my use of the car will be limited to three years but he would -- he could show that and those factors would be taken into account. Perhaps, his repair policy was not as intensive as the average repair policy. Perhaps he could show that he didn't have the usual outlay for repairs. Well, in that event, the life of the asset might have to be revised downward. Conversely, it might have to be revised upward in the event that there were factors and circumstances which showed that the taxpayer would use the asset for a longer period of time. A problem may arise when a new asset is acquired or it may arise at any time when the taxpayer is depreciating assets he already owns.
Hugo L. Black: Do you say that the duty is on him to make a report that he is different as (Inaudible) doesn't come within the category of the (Inaudible) --
Howard A. Heffron: Yes, if the taxpayer wants to change the useful life.
Hugo L. Black: Suppose he doesn't want to change it? He is satisfied with it. Is -- is it his duty to make a report if he had reason to suspect that he is getting more than he should (Inaudible)
Howard A. Heffron: Well, he fills out his return and he takes the depreciation he thinks he is entitled to.
Hugo L. Black: But he takes it -- suppose he takes it according to this form, doesn't he?
Howard A. Heffron: If he believes that the form is applicable in his instance, he takes it according to the form.
Hugo L. Black: I am -- I'm thinking of the return I started few days ago [Laughter] on a car -- on a car that the -- they fixed the value for you that -- where you make a tax return and I assume that probably although that the Government and you don't change it, they have a standard value, you're claiming here that while you do give them tentative standard burden, they do not have a right to that advantage if in fact it gives them more than they should get under the general idea of depreciation.
Howard A. Heffron: I would say that would be correct if in fact it could be shown that the circumstances were such. For example, as in these cases where in fact it has been shown in the record that the taxpayer does not keep a car for four years. He does not get zero for it when he disposes of it. He keeps it on the average and in some cases, 15 months and when he disposes off the car, he gets very substantial amounts for them coming very close to his cost. As a matter of fact, in the third case to be argued in this group, the taxpayer actually sells the cars for more than what he paid for them.
Felix Frankfurter: Mr. Heffron, if our -- we will understand the practicality a little better if you tell me when Bulletin “F” was first promulgated.
Howard A. Heffron: I believe the first edition of Bulletin “F” was 1931.
Felix Frankfurter: Well, whenever that was, what was -- how are the -- how are these situations dealt before there was a Bulletin “F”?
Howard A. Heffron: Well, we say they were dealt with in -- in precisely the same way. There is no contention. Taxpayer is not contending that. In 1931, there was a change in the practice.
Felix Frankfurter: No, no. I'm not -- I'm not thinking of the taxpayer, I'm thinking of my own understanding. What I want to know is what part of the Treasury go about or what were the rules for the taxpayer before there was this generalization, these categories, these classes as Bulletin “F” provided? Did each -- was each taxpayer pay on his own that he had to make the determination, what were the Treasury policy?
Howard A. Heffron: Well, I -- I believe that while there may not had been any official publication which listed the number of years but that has always been the basis for determining what the -- what the starting point should be whether they are economic or engineering studies or what have you -- I believe there is always been some formulation here, some model. Now, if I can give a concrete example of the results of the taxpayer's theory, let us assume that a car cost $2000, on the taxpayer's theory, he is entitled to take in the course of two years, 50% of the value of that car because he assumes it lasts four years. So he has taken a thousand dollars as a deduction for his cost of using the car. Well, if the taxpayer at the end of that two-year period sells the car for $1500, the car has only costing 500. He is taking $500 too much. One the other hand, if he sells the car for $500, but use of the car for that two-year period has cost him $1500. He is taking $500 too little. Now, if the objective here is the recovery of cost, we say that this method is purely arbitrary and only fortuitously by accident results in the recovery of cost. Under the Government's theory, if you could show as has been shown in these cases that the taxpayer customarily disposed of the car in two years and that in on the one hand, he customarily received $1500 when he dispose of it, he would only deduct 500 over the two-year period. On the other hand, another taxpayer who customarily disposed of the car in two years received $500 upon disposal, he would be entitled to deduct $1500 over the two-year period. In this way, we say that the matching of costs and income is met because after all, what we are seeking here is to match the cost of producing particular income. The car, the tangible asset, whatever it was, was used in producing income, that income is shown on the return. We're concerned with matching the cost to the taxpayer producing that income. We say the Government's theory at least theoretically permits you to recover cost in that way and have a proper matching while the taxpayer's theory results in a distortion.
William O. Douglas: I notice some page here, 118 of this record, the Court of Appeals relied seemingly to some considerable extent on the legislative history. Do you develop that in your brief?
Howard A. Heffron: Yes. We go in -- we go into the legislative history in detail and I expect --
William O. Douglas: The -- the proposals make the Congress to change this and then reduced a lot of failure, Congress (Inaudible)
Howard A. Heffron: Yes. Those were not proposals to change the depreciation rule. Those were proposals to change the rule that upon the sale of these business assets, the gain should be treated as capital gain. They were not proposals to change the basic method of computing the depreciation deduction.
William O. Douglas: The what? I -- I see some -- what reference is there to accelerated depreciation but those are at the capital gains level, are they?
Howard A. Heffron: No. The accelerated depreciation refers to a method of computing the depreciation deductions which gave greater deductions in earlier periods and that is the issue in the Hertz case which I hope to cover in my next argument.
Earl Warren: Mr. Bernhard.
Edgar Bernhard: Mr. Chief Justice and may it please the Court. From the time allotted I hope to explore three areas in very brief fashion of course. The first the peculiar paradox in which the Government finds itself as a result of this attempt to change the long established definitions of useful life and salvage value, a paradox resulting from the fact of the Government's brief in this case and counsel's argument this afternoon are completely irreconcilable with something which counsel did not mention, 40 years of consistent administration of depreciation law. Second, the repeated attempts made by the Government to get Congress to bring about the result which the Government is now asking this Court to bring about in a different method, in different way entirely by the redefinition of useful life and a salvage value, all which attempts were rejected by the Congress. Third, the very great risks the Government is taking in connection with areas of the depreciation field which are not even before the Court and that suggests and which maybe radically affected if the Government succeeds in all returning these long accepted, recognized, approved principles of depreciation in this fashion. Now, before beginning on the first of those, I do want to say preliminarily that the third case of these three old cases, the Massey case is not in our opinion a companion case. We are not interested in the third case. We do not represent the taxpayer in the third case and we consider it a case completely different from Evans and Hertz. Evans and Hertz, however, stand on the same bottom although there is a difference which we'll develop when we get into the Hertz case, a technical difference. I also would like to make sure that counsel has not inadvertently misled the Court in describing the length of time over which the taxpayer, both in Evans and in Hertz and all taxpayers for many long years back of this take depreciation. The depreciation deduction is of course actually taken, the dollar depreciation deduction is of course actually taken only for the number of years we retained the assets, the depreciable assets, but at the rate -- the rate of depreciation at -- the rate at which we depreciate the assets is the total useful life.
Felix Frankfurter: That phrase useful life, is that in a statute or Treasury Regulation?
Edgar Bernhard: It appeared for the first time, Mr. Justice Frankfurter, in a statute in the 1954 code without definition. And we say of course that the Government can hardly deny it seems to us that when Congress took the phrase “useful life” it actually took it from the regulations. And when it took the phrase useful life and used it in the 1954 code for the first time in any statute without defining it, it surely took it with whatever definitions and understandings had attached themselves to that phrase, long before over this 40-year period and that is what I'd like to describe, that definition of useful life and how it was built up. But two --
Speaker: This case -- this case does not involve -- your case as I understand it does not involve the 1954 code, the Hertz' case does, is that right?
Edgar Bernhard: That's right -- that's right, sir. However, the real point is that the Government is trying to carry back even to this Evans case which arises under the 1939 code, the same concepts, the same definitions of useful life and salvage value which -- which appeared for the first time which began so far as the Government was concerned with its 1956 regulations, it is really trying to carry back the concepts in the 1956 regulations and now first this paradox, which the Government presents to this Court. The Government is now contending for adoption of -- its definition of useful life as the taxpayer's holding period and its definition of salvage value as the value of the asset whenever it is sold, that is the price obtained for it, not the value at the expiration of the full useful life. And to hear counsel, it would seem that there really never was any other accepted idea about useful life. And just to make sure that we understand each other about useful life and salvage value and their connection, may I say this that really the issue, the solid issue, the important issue between the Government and the taxpayer in this case and in the -- the Hertz case is whether the useful life of the taxpayer's automobiles is the whole physical life. The inherent functional life for general business purposes as the taxpayer contends or the period during which the automobiles are held by the taxpayer in a given case by the given taxpayer as the Government contends. And the reason I say, that's really the solid issue between us is that the salvage value issue which of course is very important grows out of the useful life issue. If the -- and -- and the resolution of the useful life issue will automatically resolve what is salvage value because the parties agree in this case, if the Court please, that salvage value is the residue after useful life. Now, if the useful life is the whole useful life, the whole physical life of the asset, then, salvage value is the residue junk salvage value left at the end of the full useful life. If the useful life, if the proper definition of useful life is as the Government contends the holding period, then salvage value is the value at the end of that period, the end of “useful life” defined that way and it is of course greater in value then than the salvage value at the end of the full physical life, the taxpayer's definition.
Felix Frankfurter: Can I -- can I accurately rephrase the contention between you two that your conception of useful life is potential life and there's enjoyed life.
Edgar Bernhard: I beg your pardon. Is what life?
Felix Frankfurter: Your useful life for you is potential life and for them is enjoyed life?
Edgar Bernhard: As the measure of useful life which -- from which we ascertain the rate of the depreciation, not the amount and not the length of time we actually take depreciation, yes Your Honor. In our briefs, we asked the Government to give us a single case in the whole history of depreciation legislation and litigation prior to this court litigation now before this Court in which at every contended for it. Now, we didn't say establish because it is clearly never done that, but a single case in which he have had contended for the definitions for which it now contends in this case and in the Hertz case. Not a single such instance has been cited. On the other hand, we have included in our briefs cases decided by the Board of Tax Appeals by the Tax Court, by District Courts, by the Court of Appeal just to -- one or two of which I want to go into here in a moment in which the Commissioner was not just silent about what is useful life and what is salvage value, but in which he contended for three-year and four-year and five-year and six-year lives for automobiles which he knew had been sold when he made that contention after two years or after one year or after seven months. In all those cases, the Commissioner was contending that the rate of depreciation to be applied was the rate established on the basis of the full physical life of the asset, if it was four years for automobiles and there is no other testimony in either, Evans or Hertz that it is anything else, four years for automobiles and the rate of depreciation said the Government in those cases was 25%. They said that I say, knowing that the automobiles had already been sold after a much shorter period. Now, just to take a specific example; Charlie Hillard, 31 Tax Court 961 decided in 1959. Hillard was in the rental car business. He held his cars for -- from seven months to one year. What was the Government's position? The Government contended that the useful life of those automobiles was four years. It referred to the automobiles as being used by the taxpayer “for one-fourth of their useful lives and then sold.” The Government was there trying to show, since after the 1954 code and after the 1956 regulations, but the Government was they're trying to show that Hillard was a dealer and it fitted best with that argument to show that useful life was the whole useful life, four years. In the early depreciation cases before the tax --
Earl Warren: what year was that -- what year was that Mr. --
Edgar Bernhard: That case was decided in 1959.
Earl Warren: 1959.
Edgar Bernhard: In the much earlier cases in 1926, 1927, 1929 before the Board of Tax Appeals, the Government was contending for a useful life for automobiles of four years or five years despite holding periods of two-and-a-half years and three years. It was taking the same position, our position in this case and in the Hertz case, in 1942, before the Board of Tax Appeal in 1956 in the Third Circuit and even in 1959 in the Tax Court. But one of the most interesting examples to illustrate how completely the Government has about to face is Pen versus Commissioner, 199 F.2d. 210, a case decided in 1952. A rent tenant erected a building at her own expense. She proceeded to take depreciation on it at a rate based on her holding period i.e. here life expectancy. The Commission -- the Commissioner referred to that idea of taking depreciation over a useful life defined by the holding period as “a novel contention” and said there was no basis for computing annual deductions for depreciation on the basis of the period of use by that taxpayer “rather than on a basis of the useful life of the property itself.”
Hugo L. Black: What was the property there?
Edgar Bernhard: The property was a building, Your Honor. And then the Commissioner went on his brief in that case to point out what he called, “The basic fallacy in taxpayer's argument.” Now, taxpayer's argument, I must remind the Court, is the very argument which the Government makes these briefs in this case and in the Hertz case and which counsel makes this afternoon. “The basic fallacy in that argument” said the Government, “was in that taxpayer's assumption that the measure of the period of depreciation was something other than the life of property itself and that the taxpayer was disregarding” as indeed, the Government now disregards, was disregarding the fact that depreciation is a matter of wear and tear of property. And finally, the Government's brief in that case actually said, “On taxpayer's theory, every owner of the depreciable interest in property would be entitled to deduct annual depreciation at a rate based on a number of years he expects to enjoyed in, expect to live, and enjoy the income from the property instead of the number of years the property may be expected to produce income.” And in its brief in that case, the Government actually refers to the taxpayer's theory, the holding period theory the Court just heard about from the counsel as leading to “a result repugnant to the fundamental concepts of depreciation” and I must agree completely with the Government in that case.
Hugo L. Black: Why does that -- why does that apply here?
Edgar Bernhard: Because Your Honor in that case, the holding period of that building was the taxpayer's life expectancy and the Government completely inconsistently with its attempts in this case, with its attempted redefinitions in this case, held that the holding period was not to be taken as the measure of useful life, but the potential value of the building was to be taken as the useful life.
Hugo L. Black: The actual wear and tear of the building from year to year?
Edgar Bernhard: Yes, Your Honor, but -- but over the whole period of the physical life of that building, that would be, in other words, if that building was 50 years which is a standard period of useful life for a building and if that useful life for 50 years or that physical life of the building were 50 years, the taxpayer said the Government in that case, “must take depreciation at 2%.”
Hugo L. Black: I still think as you have more (Inaudible) denial of that thought.
Edgar Bernhard: Not at all, Your Honor.
Hugo L. Black: But I can't -- I -- I still can't understand why natural thing wouldn't do that you take a depreciation on the building according to effects of life without regard to the length of interest you have in the building?
Edgar Bernhard: That's correct, Your Honor.
Hugo L. Black: Your (Inaudible) said.
Edgar Bernhard: That's correct, Your Honor and that was the contention of the Government in that case I'm saying. I'm saying that now, today, and in its brief in Evans, and in its brief in Hertz, the Government is contending as if in that Pen case it had said of course you have to take the period during which the taxpayer holds the property not the period of the whole useful life. I'm saying that if the position is entirely inconsistent and Your Honor is quite correct, I'm sure that the problem, length, the proper useful life definition is the whole physical life of the property.
Hugo L. Black: I have evidently misunderstood from -- up to this time what the difference is between them. I feel that you wanted an arbitrary amount covering a certain arbitrary period whether depreciated that much or not and the Government was insisting that that was wrong.
Edgar Bernhard: No, Your Honor. May I --
Hugo L. Black: I evidently do not fully understand you.
Edgar Bernhard: May I -- I perfectly have made myself clear and I -- I certainly would like to. We -- I think what has misled Your Honor is the reference to four years for automobiles and it is true that it is prescribed in Bulletin “F” by the Government as the useful life of automobiles. It is true also that the testimony in Evans and in Hertz, both was that the useful life, the full physical life of automobiles is four years. If we hold the automobiles for one year or two years or three years, we actually deduct depreciation from cost only of course for the length of time we hold it, but at the rate -- at the rate established by the whole physical life of the asset, and if the whole physical life of the asset is four years, then we deduct depreciation during the period we continue to use the automobiles at 25% per year.
Hugo L. Black: Well, may I ask you one question. Let's suppose that you are importunate enough in our business to be able to get less wear and tear each year then somebody else, is it your insistence that even though your wear and tear is less each year, you still take the full amount that you would get if you were the normal man?
Edgar Bernhard: Your Honor, I have to ask whether you are presuming, Mr. Justice Black, whether you're presuming excessive use or holding.
Hugo L. Black: I don't understand all those words about use, useful life and so forth.
Edgar Bernhard: Well, Take automobiles for instance. I think I can make it very clear, I hope I can, take automobiles. If I operate my automobiles 16 hours a day, instead of eight let's say, or 24 hours a day, in a taxi cab doesn't, three chauffeurs operating the automobiles, that excessive use is wear and tear and that excessive wear and tear will reduce useful life, the whole physical life of the asset, it's true. And the four-year period assumes normal use, normal repair policy, maintenance policy such as -- it was testified to were followed in Evans and in Hertz. And if Your Honor is saying, if in excess business, he operates machines or automobiles or any depreciable assets at excessive use and therefore the useful life is only two years let's say, it is true then that that is the rate that -- that would be established. That would establish the rate at which you take depreciation. If it were two years, the rate would be 50%.
Hugo L. Black: What I understood was, I guess I'm still don't understand. I understood he was claiming -- they were claiming that what you insist on is by reason of a four-year formula or whatever it is, that you're entitled to get a greater amount of depreciation per year than you actually suffer. You're doing it on the basis of what somebody else doesn't.
Edgar Bernhard: No. I do think that inadvertently counsel -- perhaps gave you Your Honor the idea that we take depreciation. That is we actually deduct depreciation over a four-year period, even if we only hold the cars for two or three. That we do not do. We take depreciation, actually deduct depreciation --
Hugo L. Black: But do you take -- do you take more under the formula you have than you actually suffer?
Edgar Bernhard: No, Your Honor, we do not.
Hugo L. Black: (Inaudible)
Edgar Bernhard: We -- we do not. We take --
Hugo L. Black: You do not -- you do not attempt than just to follow the rule that they've said is the normal rule?
Edgar Bernhard: Yes, Your Honor, we do but in a different way because we do not get more depreciation that we're entitled to for more than is reflected by wear and tear because that --
Hugo L. Black: (Inaudible) that you're entitled to and -- I keep asking you this because (Inaudible) --
Edgar Bernhard: Sorry.
Hugo L. Black: -- you get more what you're entitled to would you not if you are actually charging on more depreciation than you suffer in a year.
Edgar Bernhard: That's right, Your Honor. That is not contended for here.
Hugo L. Black: You say you're not doing it?
Edgar Bernhard: That is not contended. We operate our cars on the normal basis. We operate our cars with normal repair and maintenance and that brings us within the normal rule, the four-year rule.
Hugo L. Black: Then you -- then you are insisting that the rule has to be followed whether you actually suffer that depreciation or not.
Edgar Bernhard: Yes, Your Honor. All -- we don't suffer four years of depreciation. I don't want to be giving Your Honor that impression. We don't suffer four years of depreciation, but if we hold the car for two years, we suffered two years of depreciation and that is the length of time during which we deduct depreciation at a 25% rate, at a 25% rate.
Hugo L. Black: Whether you suffered or not?
Edgar Bernhard: Well, Your Honor, whether we suffer or not.
Hugo L. Black: I mean, you actually suffered or not?
Edgar Bernhard: Yes, Your Honor, whether we suffered or not.
William J. Brennan, Jr.: Mr. Bernhard, I assume there must be a dollars and cents difference between your positions here. I mean, perhaps you can help me understand what this is all about and I don't understand it for my self. Can you take an illustration of the automobile which cost $2000 that you hold for year and dispose of for $1000 and tell me what the difference tax wise is between you and the Government?
Edgar Bernhard: Yes, Your Honor. An automobile -- I think we're talking about straight line depreciation now. A depreciable asset is purchased let's say for $1000. It has a 10-year useful life. It is -- therefore, the rate of depreciation to be taken is 10%. Now, it is agreed that under straight line, salvage value shall first be deducted. And let's say that salvage value is $50 at the end of the useful life would be $50. That is to make its salvage value as first deducted and $950 is then the adjusted basis which is to be depreciated at the rate of 10% per year. And if the owner continues to hold it according to the counsel for the Government, for only two years, he takes depreciation on the basis of two years. On our basis that the way --
William J. Brennan, Jr.: Well, then, he takes depreciation on the basis of two years. In your illustration how much does that mean to you?
Edgar Bernhard: On the basis of a two-year life.
William J. Brennan, Jr.: Two-year life?
Edgar Bernhard: We held it for five years let's say which is --
William J. Brennan, Jr.: I wish you'd use dollars and cents, frankly I just don't get it the way you're putting it.
Edgar Bernhard: All right, Your Honor. On our contention, the $950 would mean deduction of depreciation at the rate of $95 per year and we would take $95 for the first year and $95 for the second year and as for many years as we continue to use the asset.
William J. Brennan, Jr.: And I suppose you dispose of it at the end of five years.
Edgar Bernhard: At the end of five years, we would no longer be deducting depreciation and -- and if it were sold at the end of five years for $500, the difference between the $500 and the amount to which we had depreciated the asset would be taken as a capital gain.
William J. Brennan, Jr.: Well this -- on your hypothesis, you would have depreciated the asset $95 a year --
Edgar Bernhard: That's right –
William J. Brennan, Jr.: -- times five?
Edgar Bernhard: Right.
William J. Brennan, Jr.: $475, there would be $25 gain, is that it?
Edgar Bernhard: That's right.
William J. Brennan, Jr.: You sold it $500.
Edgar Bernhard: And we would have depreciated that at $475.
William J. Brennan, Jr.: Yes.
Edgar Bernhard: The $475 would be deducted from $100 -- from $1000, I'm sorry, it will be deducted from $1000 and the adjusted basis would be the difference i.e. $525. If we sold it for $600, we would take $75 as the capital gain.
William J. Brennan, Jr.: All right, now, that's on your approach to this problem?
Edgar Bernhard: Yes, Your Honor.
William J. Brennan, Jr.: Now, what on the Government's approach?
Edgar Bernhard: The Government's approach -- the Government's approach results in elimination of any possibility for capital gain if salvage value is properly estimated at all. The Government says --
Potter Stewart: Well, using -- using the same figures.
Edgar Bernhard: Yes, using the same figures. The Government says, $1000 -- $1000 asset which you estimate, you are going to hold for five years means that you can take a 20% per year deduction and therefore, you can take 20% of $950 each year while you hold it. The deduction of salvage value however, changes the $950 figure. It is no longer $950 figure for the Government because the Government starts with $1000, says you estimate not only your holding period, but the salvage value i.e. the price you're going to get for the asset and if you estimate that you are going to get $500 for the asset --
William J. Brennan, Jr.: At the end of five years?
Edgar Bernhard: At the end of five years, you take the $500 from $1000 before you begin depreciation. So, that although you are entitled to 20% depreciation per year, you take it on $500.
William J. Brennan, Jr.: Which wipes it out it at the end of five years?
Edgar Bernhard: Yes, Your Honor and therefore, when you sell, no capital gain because it balances of course. The undepreciated balance or adjusted basis will always equal, the price you get.
William J. Brennan, Jr.: Now, let's (Inaudible) always of the application of the Government's formula?
Edgar Bernhard: I beg your pardon.
William J. Brennan, Jr.: Would this be the consequence always of the application of the Government's formula?
Edgar Bernhard: Except, Your Honor, in the case of -- a misestimate. In the case of -- an estimate of a different amount of sale price obtainable there might be a difference and one of our contentions is in fact, Your Honor that --
William J. Brennan, Jr.: Let's just figure out.
Edgar Bernhard: That there is a -- a reward for one who underestimates your salvage value whereas a taxpayer who correctly estimates his salvage value is going to have no capital gain. Now, the -- it's -- the Government puts its argument always whether it is arguing for holding period as it is in Evans and Hertz, or arguing for full useful life which is the four-year definition of useful life and always puts its arguments in terms of the fundamental concept of depreciation. In Pen, it was insisting that the fundamental concepts of depreciation required retention of this long established definition of useful life as the full physical life of the property. And now, in Evans, it refers again although it is now saying it isn't the full physical life which determines the rate of depreciation, it's only the period in which you hold it. It is now again saying the -- this is in keeping with the fundamental concepts of depreciation, on one occasion of this spoke of the settled concept of depreciation, but this time it's the holding period that's for -- that's the settled concept. As to the second area of discussion, the repeated efforts of the Treasury Department to convince the Congress that it should make the changes which would lead to the same result for which it's -- asking this Court. At least one of us appealing to Congress, the Treasury was in the right form. It made four attempts, futile attempts, to get the Congress to make changes which would result in the result that asking for here. The first of those was in 1947 at eight for the House Ways and Means Committee. The Government asked Congress to reduce the effect of the capital gain section by treating gains realized on the sale of partially depreciated assets as ordinary income. And as the Ninth Circuit pointed out below, the Treasury Department in reports to the House Committee pointed out that there was a revenue loss resolving from the taking of capital gains on the sale of depreciable assets, but the Congress took no action. The second attempt was in 1950. The Treasury pointed out to Congress that gains on the sale of depreciable assets are treated as capital gains, but that if the taxpayer takes a lost, he can treat it as an ordinary lost against ordinary income and asked Congress to change that so that it would not be as they said a one way street but that the loss would be a capital loss only, the Congress refused to do so. When the third attempt was made, it was made in the Courts in the Filbert case in 1956, Third Circuit case, and also at first in this Evans' case by attempting the elimination of -- of -- or at least drastic reduction of capital gains in connection with the sale of automobiles used in renting and leasing. Not having succeeded with Congress, it tried the courts, but the Court in Filbert would not permit them to maintain as they tried to do in Evans' also that the taxpayer in a renting and leasing business was a dealer in automobiles and therefore could not take depreciation at all and the attack was abandoned by the Government in the Evans' case.
Earl Warren: Mr. Heffron, would you mind just before you start to answer what the counsel had to say about never before this particular case, was there any case that the counsel could -- that you could cite where the Government have maintained its present position?
Howard A. Heffron: Well, I was just going to say to the Court the language which has consistently appeared in the regulations and which this Court adopted through Mr. Justice Brandeis in the Ludey case some time ago, that language speaking of depreciation is the amount of the allowance to a 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 --
Earl Warren: In the business?
Howard A. Heffron: In the business, plant in the business, the aggregate of the sum set aside will -- with the salvage value what is received when he disposes of it, suffice to provide an amount equal to the original cost and I'd like to make three observations with respect to that quotation which is one which has appeared in the regulations consistently which this Court placed as part of its opinion in the Ludey case and which while it appeared in the regulations, saw Congress re-enact 10 times the applicable provisions of the Internal Revenue Code. Now, first --
Felix Frankfurter: Will you tell us -- will you tell us whether as a matter of Treasury practice involving situations like Evans, what actually has been the dollar and cents application of what you just read?
Howard A. Heffron: The dollar and cents application --
Felix Frankfurter: Has it been your way or Mr. Bernhard's way?
Howard A. Heffron: It has been our way but I would concede that the problem raised by the rental car business is a relatively new one because this is a relatively new business, but there are analogous situations where it is quite clear that the Treasury has applied the same principles and I was going to refer to them.
Hugo L. Black: As a tax court ever decided it differently to this case?
Howard A. Heffron: No. The cases which the counsels cites are cases which used the term useful life in the sense in which Mr. Justice Frankfurter used that, in the model, in the abstract sense and -- those were cases where the question was, is the taxpayer holding the cars to sell them or is he holding them for some other purpose? And the Government said, “Well, he's holding them less than the useful life” meaning the abstract model, useful life sense, therefore, he's not holding them to use them out. He's holding them to sell them. That was the only point of using the term in that way and there has to be a way to describe this abstract concept, this model useful life, but it's always applied to the taxpayer and what we are talking about in these cases are not useful life in the abstract, but the taxpayers useful life because we're trying to give the taxpayer back his cost in terms of tax deductions and to define useful life in terms which have no pertinence or relevance to the taxpayer's own cost or his own mode of operation. It gives no guarantee whatever that he will recover his cost through the depreciation deductions because after all, the regulation provides that the proper amount is the amount which should be aggregated. Now, we say that aggregate amount must assume that we're talking about an aggregation which will occur over a period that a taxpayer is using the property because to aggregate it over some other period makes no sense as -- for example in the taxpayer's example of asset which has a 10-year abstract life, if you know the taxpayer will sell it in two years or in five years to aggregate 10% a year for two years or five years does not give the taxpayer back his cost. We say in that situation, you must take a period of time to with the time the taxpayer reasonably expects to use the property whether a two, five, or 10 years then you have a period whose aggregate will realize cost, otherwise, you cannot realize cost.
Speaker: Could I go back to the question that Chief Justice put to you? Have you got any litigated case either in the Tax Court or in District Court where the Government has taken the position, it's taking in these cases?
Howard A. Heffron: Other than this case and the cases here --
Speaker: Your answer to the Chief Justice in terms of your 1942 -- you schedule that for your 1942 regulation. The question I thought he asked was you could point to any case or litigated case where the Government has taken this position other than these three cases?
Howard A. Heffron: Well, one case which comes to me off hand is the recent Collin case in the Sixth Circuit where the Sixth Circuit adopted a view that useful life shall be the period which the taxpayers actually holding the property rather than some other abstract model period.