The following article is adapted and reprinted from the M&A Tax Report, Vol. 10, No. 5, December 2001, Panel Publishers, New York, NY.

INDOPCO COALITION WEIGHS IN

By Robert W. Wood

It is no secret that since the Supreme Court decided INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992), taxpayers have been scratching their heads trying to make sure that, as much as humanly possible, they fall outside INDOPCO's capitalization net and into the land of milk, honey and ordinary business expense deductions. Like much of the tax law in other areas, the law on capitalization has developed piecemeal, with other cases since INDOPCO putting their own spin on this important area, the Internal Revenue Service continually tweaking what it perceives to be the important scope of INDOPCO in various rulings and tech advice memos, and perhaps least publicly, practitioners simply dealing with capitalization principles as best they can.

Although INDOPCO involved takeover expenses, and a number of post-INDOPCO cases dealt with this particular concern. The Service has by no means been limited to such a myopic view of capitalization. Indeed, while practitioners struggled with the hostile vs. friendly distinction implicit in INDOPCO, and the courts had to wrestle with just what were the earmarks of acquisition expenses that had to be capitalized vs. deducted, a good part of this may have been due to timing. For an important case on INDOPCO, see A.E. Staley Manufacturing Co., et al. v. Commissioner, 105 T.C. 166 (1995), rev'd and remanded, 119 F.3d 482 (7th Cir. 1997).

Bear in mind that INDOPCO was decided in 1992, and from that point through the rest of the 1990s, acquisitions in the United States (and worldwide) grew at an incredible pace. Even limited to acquisition expenses, INDOPCO was an enormously important case. But from the sublime to the ridiculous, INDOPCO turns up as a major citation in a wide range of factual settings. For example, INDOPCO turns up in authorities dealing with the removal of telephone poles (Rev. Rul. 2000-7, 2000-9 I.R.B. 712), the overhaul of commercial airlines (Rev. Rul. 2001-4, 2001-3 I.R.B. 295), and even regular old advertising expenses (Rev. Rul. 92-80, 1992-2 C.B. 57). Some of these notions now seem fanciful (or to put it more assertively, downright stupid). Even government-friendly (and generally big business) anti-commentators like Lee Shepherd have pointed out that some of the INDOPCO extensions — such as the capitalization of advertising expenses — are unlikely to be followed by just about anyone. See Shepherd, "The INDOPCO Grocery List," Tax Notes, October 15, 2001, p. 320.

Coalition Proposal

On September 6, 2001, the "INDOPCO Coalition" (okay, it sounds a little like the mafia), put forth a weighty proposal to harmonize the admittedly inconsistent and generally messy area of capitalization. The INDOPCO Coalition is made up of large U.S. companies engaged in a wide variety of business activities. The coalition has three professional representatives, the law firm of Skadden, Arps, Slate, Meagher & Flom, and the accounting firms of KPMG and Ernst & Young. Delivered with a letter to Commissioner Rossotti, the Coalition notes the importance of INDOPCO, and yet the published position of the Treasury and IRS that INDOPCO did not change the fundamental legal principles for determining whether costs must be capitalized. See Notice 96-7, 1997-1 C.B. 356. Still, reality may be different.

The Coalition believes that they have set forth an "administrable and practical framework for addressing capitalization issues by providing objective principles that draw lines between capital expenditures and deductible expenses." Safe harbors and rules of convenience are also provided to make matters easier on everyone. Copies were provided not only to the Commissioner, but also the Office of Tax Policy, the Office of Chief Counsel, to the Tax Writing Congressional Committees, as well as the Joint Committee on Taxation.

The Proposal is organized into four Parts: Introduction; ACORN Transactions (acquisition, creation, organization, reorganization, and new separate trade or business investigation and creation transactions); Business Operations; and Repairs and Capital Improvements.

I. INTRODUCTION

Part I sets forth the general requirements regarding capitalization. The Proposal exempts costs or transactions the tax treatment of which is specifically governed by other provisions in the Code or Regulations. Thus, costs required to be capitalized under the uniform capitalization rules set forth in section 263A would not be affected by the Proposal.

II. "ACORN TRANSACTIONS"

Part II sets forth principles regarding certain extraordinary transactions, including acquisition, creation, organization, reorganization, and new separate trade or business investigation and creation transactions ("ACORN Transactions"). The Proposal provides that taxpayers must capitalize consideration paid in an ACORN Transaction (including debt assumed or acquired) and transaction costs of accomplishing or consummating the ACORN Transaction.

The Proposal provides guidance for determining whether a taxpayer in an existing business is entering a new separate business or expanding an existing business. Eleven different factors are relevant, any one of which can indicate a continuation of the taxpayer's existing business. Numerous examples are provided. The Proposal reflects the notion that technology and the competitive environment require companies continuously to explore different ways of doing business, and reflects the view that these changes should not be treated as entering a new trade or business. For example, a retail concern that historically has sold its products at fixed locations is not treated as entering a new trade or business simply because it begins distributing its products by mail or over the Internet.

The Proposal also provides examples of consideration paid in ACORN Transactions, of transaction costs of accomplishing or consummating an ACORN Transaction, and of transaction costs that are deductible. To the extent not amortizable under another provision of the Code or regulations, ACORN Transaction costs required to be capitalized under the Proposal (including the costs of entering a new separate trade or business) are amortizable over five years unless the taxpayer chooses a longer recovery period. The Proposal's five-year recovery period for capitalized ACORN Transaction costs is consistent with the five-year recovery periods currently provided in section 195 (start-up expenditures), section 248 (organizational expenditures of corporations), and section 709 (organization of syndication fees of partnerships). By specifying a safe harbor amortization period for ACORN Transactions, the Proposal facilitates resolution of factual disputes that may arise between the IRS and taxpayers.

III. BUSINESS OPERATIONS

Part III of the Proposal provides principles regarding the deductibility or capitalization of costs incurred during ordinary business operations (apart from repairs and capital improvements). The Proposal sets forth the general rule that costs of operating, protecting, maintaining, improving, or expanding an existing business are ordinary within the meaning of section 162 and are not subject to the capitalization rules of section 263. This is consistent with the principles of Briarcliff Candy Corp. v. Commissioner, 475 F.2d 775 (2d Cir. 1973), and NCNB Corp. v. United States, 684 F.2d 285 (4th Cir. 1982). Business operation and expansion costs are generally deductible.

The Proposal mimics current law that costs incurred during business operations must nonetheless be capitalized if the costs are costs of (i) acquiring an asset, (ii) producing a tangible asset, (iii) creating a separate and distinct intangible asset, or (iv) defending or protecting title to an asset.

The Proposal defines an "asset" as any interest in real or personal property (tangible or intangible) that (i) either is acquired for resale or has an economic useful life in excess of twelve months and (ii) has an ascertainable and measurable value in money's worth in and of itself. Under this definition, taxpayers are allowed a deduction for costs of acquiring an asset or creating a separate and distinct intangible asset with an economic useful life of less than one year. A one year rule is contrary to the Tax Court's holding in USFreightways v. Commissioner, 113 T.C. 329 (1999) (requiring capitalization of the costs of licenses, fees and permits with a useful life of less than one year). However, a one year rule is consistent with numerous other authorities. See, e.g., Zaninovich v. Commissioner, 616 F.2d 429 (9th Cir. 1980) (holding deductible in 1973 a payment for rent from December 1973 to November 1974); Rev. Rul. 69-81, 1969-1 C.B. 137 (allowing a deduction for the cost of clothing, towels, and other items with a useful life of one year or less). A one year rule also is consistent with the overriding objective of providing an administrable and workable set of rules that properly balances various tax policy goals.

A "separate and distinct intangible asset" is defined in the Proposal as an intangible "asset" that commonly is acquired separately from a trade or business or could be so acquired if restrictions on assignability were ignored. The Proposal enumerates examples of separate and distinct intangible assets (e.g., a copyright, franchise right, trademark, trade name, lease agreement, license agreement, loan agreement, membership, covenant not to compete, a right to conduct a specific type of business, an exclusive right to operate in a specified geographic area, and certain contract rights to sell or buy goods or services). The Proposal expressly excludes from the definition of "separate and distinct intangible asset" a number of intangible assets described in section 197 (e.g., goodwill, going concern value, work-force-in-place, information base, formulas, processes, patterns, know-how, format, graphic design, and package design, certain customer-based intangibles and certain supplier-based intangibles).

The Proposal provides an exclusive list of the types of transactions that require capitalization of costs. Thus, a cost that is not a cost of an ACORN Transaction and that is not required to be capitalized by another provision of the Code is required to be capitalized under the Proposal only if the cost is a cost of acquiring an asset, producing a tangible asset (including a capital improvement), creating a separate and distinct intangible asset, or defending or perfecting title to an asset. Costs that are not required to be capitalized under these principles but that nonetheless enhance the value of the taxpayer's business are more akin to costs of creating goodwill and other intangibles that are not separate from the business itself. These costs are deductible under the Proposal regardless of the magnitude of the costs or the infrequency with which the costs are incurred. For example, under the Proposal, costs incurred for reengineering business processes or for improving a distribution network are deductible.

In a few cases, courts have required capitalization of costs incurred during business operations even though the costs were not costs of an ACORN Transaction or of acquiring an asset, producing a tangible asset, creating a separate and distinct intangible asset, or defending or perfecting title to an asset. See, e.g., Houston Natural Gas Corp. v. Commissioner, 90 F.2d 814 (4th Cir. 1937) (taxpayer required to capitalize salaries and expenses of solicitors employed by it as part of a successful campaign to get new business of a lasting or permanent character); Public Opinion Publishing Co. v. Jensen, 76 F.2d 494 (8th Cir. 1935) (requiring capitalization of costs of contests held to increase circulation of publication). We believe that these cases are not consistent with the weight of authorities allowing deductions for advertising and business expansion costs. Moreover, they are inconsistent with policy judgments of Congress, and they purport to draw lines that cannot be administered in practice. They also reach results that generally would over-tax affected taxpayers on their economic income, and are not consistent with business realities. The effect of the Proposal is to reach results that differ from the results reached in these decisions.

Costs That Must Be Capitalized

The Proposal provides principles for identifying costs that must be capitalized. For assets acquired for resale and the production of tangible assets, rules for determining what costs must be capitalized are set forth in section 263A and the regulations. In the case of other asset acquisitions or the creation of separate and distinct intangible assets, taxpayers must capitalize consideration paid or incurred (including debt acquired or assumed) and certain transaction costs of accomplishing or consummating the acquisition or creation of the asset.

Deductibility of Certain Recurring Costs

In identifying costs that must be capitalized, the Proposal provides current deductibility for certain recurring costs without regard to whether the costs might be incurred in acquiring assets or creating separate and distinct intangible assets. These principles would achieve the goal of administrability, plus substantially reduce the burden on both taxpayers and the IRS without resulting in distortion of income. Except where capitalization is otherwise required by the Code or regulations, the Proposal provides current deductibility for (i) general and administrative costs, (ii) employee compensation regardless of the form in which paid; and (iii) de minimis costs described in a written policy of the taxpayer applicable for tax purposes and all significant non-tax purposes. Certain of these rules also apply in the case of ACORN Transactions, defense or perfection of title, and capital improvements.

Some courts have required capitalization of employee compensation in general (e.g., Lychuk v. Commissioner, 116 T.C. No. 27 (2001) (requiring a taxpayer in the business of servicing installment contracts to capitalize the portion of its employee's salaries directly related to the successful acquisition of installment contracts)), and particularly where the compensation would not have been incurred "but for" a capital transaction (e.g., Pier v. Commissioner, 96 F.2d 642 (9th Cir. 1943) (requiring capitalization of a stock commission paid to the taxpayer's president for consummating a reorganization contract)). However, a rule allowing a deduction for employee compensation is consistent with existing authorities. See, e.g., Wells Fargo Co. v. Commissioner, 224 F.3d 874 (8th Cir. 2000) (allowing a deduction for officer salary expenses that were directly related to and arose out of the employment relationship even though relating to work performed with respect to a corporate acquisition); PNC Bancorp Inc. v. Commissioner, 212 F.3d 822, 830 (3d Cir. 2000) (allowing a bank a deduction for employee salaries and benefits attributable to time spent completing and reviewing loan applications, and to other efforts connected with loan marketing and origination).

A rule allowing deduction of employee compensation also accomplishes the Proposal's objectives of providing administrable and workable rules that achieve an appropriate balance among important tax policy objectives. Allowing a deduction for all employee compensation, even if the compensation would not have been paid or incurred but for a transaction, is justified on grounds of consistency in treatment of employee compensation regardless of the form in which paid and the importance of minimizing the impact of capitalization rules on how businesses choose to compensate and reward employees.

The Proposal also provides a deduction for all selling expenses and other transaction costs incurred in the taxpayer's routine income-producing activities. Thus, in the case of a taxpayer in the business of lending money or financing, although the taxpayer would not be permitted to deduct the loan proceeds paid to borrowers or the amounts paid to acquire loans, the taxpayer would be allowed a current deduction for all transaction costs of originating or acquiring the loans. In the case of a taxpayer in the business of leasing equipment, although the taxpayer would be required to capitalize and amortize amounts paid to lessees to induce the lessees to enter into leases, the taxpayer would be allowed a current deduction for all transaction costs of originating the lease contracts.

Similarly, for a taxpayer in the business of selling goods or services, the transaction costs of entering into contracts with customers providing for the sale of those goods or services would be deductible, even if the contract rights to sell the goods or services were separate and distinct intangible assets. Allowing a deduction for these routine and recurring costs achieves the goal of administrability and substantially reduces burden on both taxpayers and the IRS, without resulting in distortion of income.

IV. REPAIRS AND CAPITAL IMPROVEMENTS

Part IV of the Proposal sets forth principles regarding expenditures to repair, maintain, rehabilitate, or improve tangible assets. The Proposal provides an elective repair allowance system that is considerably more objective than current law. The Proposal also provides additional guidance for applying the principles of current law to expenditures that are not subject to the elective repair allowance system. The elective system, referred to as the Modified Repair Allowance System ("MRAS"), is modeled on the former ADR repair allowance system. See Treas. Reg. section 1.167(a)-11(d)(2).

A Modest Proposal?

It is only optimistic to think that the Coalition's proposal will garner immediate recognition from either the Service or anyone else. The few indications thus far suggest that this weighty proposal was seriously thought out and should be seriously considered. Just how long it may take the Service to do the right thing — to address this long confused area — remains to be seen.

INDOPCO Coalition Weighs In, Vol. 10, No. 5, The M&A Tax Report (December 2001), p. 1.