Opinion ID: 2604259
Heading Depth: 1
Heading Rank: 9

Heading: Deferred Income Taxes (DIT)

Text: Most railroad assets are long-lived. These assets are depreciated, for normal (straight-line) accounting purposes, over a 10-year period. Depreciation is an offset against income for income tax purposes. NROI, which Schoenwald used as his basis for projecting future income streams, is an after-tax figure, i.e., all taxes are deducted from gross operating revenues in order to determine NROI. But, during the years in question, special tax rules enabled UP (like many other businesses) to accelerate its depreciation deduction for income tax purposes so that a portion of UP's operating income was offset (or sheltered, as the Tax Court put it), and NROI was reduced correspondingly for the years in question. Accelerating depreciation means that, in later years, it will not be possible to take as large a deduction for depreciation on the same asset as one would be able to take under traditional, straight-line accounting; most of the depreciation allowance will have been exhausted. Thus, taxes for the later period will be higher. Those higher taxes in later periods are anticipated by setting up an account, called deferred income taxes (DIT), which represents the amount that UP deducts from current income beyond traditional straight-line depreciation. The amount is treated as a cash reserve set aside for payment of higher taxes later, although the cash that it represents is available in the interim for other uses. Because DIT represents an amount of cash available to UP but not included in NROI, the Department argues that NROI is understated. The Tax Court agreed in part, but only to the extent that future amounts of DIT would be sheltered permanently in the asset base by ever-increasing asset purchases and offsetting accelerated deductions for depreciation of those future assets. UP argues that no part of DIT should be added to NROI. The Tax Court explained its view on this point at some length: The court finds that both parties failed to properly account for DIT. The provision for deferred taxes, as found in the Form R-1s, is further explained on Schedule 450, entitled `Analysis of Taxes.' That schedule states that under Part B are `the particulars which most often cause a differential between taxable income and pretax accounting income.' Examining Exhibit I-3, at 62 and 65, the Form R-1 for [UP] for 1982, discloses that not all of the deferred taxes are attributable to accelerated depreciation. In fact, a number of items such as contested property taxes are not longterm deferral items. Likewise, the Form R-1s for Missouri Pacific show greater amounts due to special depreciation allowed by the Economic Recovery Tax Act of 1980 than due to accelerated depreciation. Exhibit K-3, at 62, shows that, of $100,565,000 of DIT, only $25,777,000 can be attributed to accelerated depreciation. Likewise, on Exhibit N-3, at 61, of $97,507,000 of DIT, only $18,167,000 is accelerated depreciation. It would appear that specific adjustments underlying the provision for deferred income taxes must be analyzed before adjusting the cash flow. The Economic Recovery Tax Act (ERTA), Public Law 97-34 enacted August 13, 1981, § 203(c), contained a transitional provision which allowed the railroads to write off their `frozen base' over five years, using accelerated depreciation. It would be error for [the Department] to add back the full amount of that special ERTA depreciation since it will not last indefinitely into the future. Likewise, it would be error for [UP] to subtract all ERTA deductions since they do not entirely represent accelerated depreciation. To the contrary, in many ways the ERTA deductions were catching up with straight-line depreciation. The court has additional questions concerning the continuance or permanency of deferred income taxes attributable to accelerated depreciation. [UP] assumes that depreciation equals capital expenditures and, therefore, that there is no benefit from DIT. However, [UP] acknowledges that, due to inflation, capital expenditures will generally exceed depreciation. [UP] appears to ignore that difference on the theory that it is caused by property being acquired in the future and, therefore, is not now subject to tax. [The Department], on the other hand, assumes depreciation is less than capital expenditures and so adds back the DIT. It is appropriate to recast income to accurately reflect cash flow.    In this case, it appears to the court that it would be reasonable to adjust cash flow to include the deferred income taxes which appear to be permanently sheltered by the ever-increasing asset base. This would exclude deductions attributable to ERTA.    To reiterate, what we are looking for here is expected cash flow. The court finds that capital expenditures are expected to exceed depreciation, which means that the DIT will be permanently deferred. As long as the parties are using perpetuity models to value an existing pool of assets, then deductions from net cash flow such as DIT should have the same long-term implications. Union Pacific Railroad v. Dept. of Rev., supra, 11 OTR at 172-74 (citations omitted). We agree with the Tax Court's conclusion as to the portion of the amounts labeled DIT for each of the two years that should be added to NROI in determining the relevant cash flows.