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Rev. Rul. 78-264, 1978-2 CB 9

REV-RUL, Investment credit; seed trees; timber producer., Rev. Rul. 78-264, 1978-2 CB 9, (Jan. 01, 1978)

Section 48.--Definitions; Special Rules

26 CFR 1.48-1: Definition of section 38 property.

Investment credit; seed trees; timber producer.
Trees comprising a timber producer's seed orchard that are used to produce genetically superior seedlings for the producer's timber growing operation are section 38 property. They are placed in service when they bear sufficient seed to warrant harvesting.

Advice has been requested whether, under the circumstances described below, the trees comprising the taxpayer's seed orchard are "section 38 property" within the meaning of section 48(a) of the Internal Revenue Code of 1954.

The taxpayer is in the business of growing timber for use in its lumber, plywood, and wood pulp plants. In order to grow more high quality timber in a shorter time the taxpayer, after harvesting a tract of timber, reforests it with genetically improved seedlings. The large quantity of genetically improved seedlings used by the taxpayer for this purpose each year are not available by purchase from tree nurseries.

To assure a supply of genetically improved seedlings for its reforestation needs, the taxpayer established a seed orchard. Rootstock grown from ordinary forest tree seed of the proper species are planted. Scionwood (small branchwood) is collected from parent trees that exhibit certain characteristics that make them superior timber-producing trees. After the rootstock is established, a scion from one of the parent trees is grafted onto each rootstock. After several years, the grafted trees begin to bear cones that are harvested and the seed extracted. The trees produced from this seed generally exhibit the superior growth and form of the parent trees.

This genetically superior seed is sown in nursery beds and the genetically improved seedlings produced therefrom are used to reforest the taxpayer's land.

The selection of superior parent trees is ongoing. By the time the grafted trees are 20 years old, a replacement orchard will be ready to produce seed genetically superior to the trees in the original seed orchard. At that time, the original seed orchard will be abandoned and the trees removed.

Section 48(a)(1) of the Code provides that the term "section 38 property" means property that is tangible personal property or other tangible property if such other property is used as an integral part of manufacturing, production, or extraction. Such term includes only property that is depreciable and has a useful life of 3 years or more.

Section 167(a) of the Code provides that a reasonable allowance for exhaustion, wear and tear, and obsolescence of property used in the trade or business shall be allowed as a depreciation deduction.

Section 263(a) of the Code provides that generally no deduction shall be allowed for capital expenditures. A capital expenditure is one that creates, or results in the permanent improvement or betterment of an asset that has a useful life greater than 1 year.

Citrus trees growing in an orchard are section 38 property within the meaning of section 48(a)(1) of the Code and they qualify for the investment credit provided by section 46(a). Rev. Rul. 65-104, 1965-1 C.B. 28, and Rev. Rul. 69-249, 1969-1 C.B. 31.

Trees growing in fruit orchards and held for the production of income are "other tangible property" within the meaning of section 48(a)(1) of the Code. Rev. Rul. 67-51, 1967-1 C.B. 68.

To establish a seed orchard for the production of superior tree seed, the taxpayer paid or incurred certain costs, such as those for the acquisition and planting of seedlings to be used as rootstock, selecting parent trees, collecting scionwood from the parent trees, and grafting a scion to each rootstock. These costs, along with any others that are properly includible, are capital costs of establishing the seed orchard in accordance with section 263 of the Code and the regulations thereunder. Rev. Rul. 75-405, 1975-2 C.B. 64, holds that the costs of raising pistachio seedlings from seed through grafting the rootstock, similar to the costs in the instant case, are capital costs rather than deductible business expenses.

The trees in the seed orchard are depreciable property, an integral part of the taxpayer's production of seed for use in its timber growing operations, and "other tangible property" within the meaning of section 48(a)(1) of the Code. They are placed in service when they bear cones in a quantity sufficient to warrant harvesting for seed. They will have a remaining useful life to the taxpayer of more than 3 years at that time.

Accordingly, the trees comprising the taxpayer's seed orchard are "section 38 property" within the meaning of section 48(a) of the Code.