"Bailout" payments made by bank to its proprietary mutual funds must be capitalized.

In a recent (not yet published) field service advice (FSA) memorandum, the IRS National Office advised that a bank acting as an investment adviser for its proprietary mutual funds was required to capitalize payments that the bank made to its money market funds to prevent the funds from falling below their targeted net asset values (NAVs). The FSA emphasized that the payments preserved the long-term benefits of the funds to the bank by sustaining its "core retail franchise" However, the FSA clearly suggests that the National Office may be generally predisposed to requiring capitalization of such payments, regardless of the particular circumstances surrounding the investment adviser or the payments.

Business Purpose of Bailout Payments

Although typically under no contractual obligation to do so, investment advisers occasionally infuse cash into a bond fund to return the fund to its targeted NAV. Investment advisers often make such payments (usually referred to as bailout payments) primarily to avoid potential shareholder litigation. In other contexts, investment advisers may similarly make "correction" payments to funds in connection with certain errors made to the detriment of the funds, such as tax return Preparation mistakes.

In the FSA, the taxpayer was a large commercial bank that served as the investment adviser for a family of proprietary mutual funds, including two money market funds that the taxpayer had acquired in a merger with another bank. Because of rising interest rates, the value of certain securities held by the money market funds declined, causing the NAV of each fund to fall below $1.00 per share (known as "breaking a dollar"). To eliminate the NAV deficiencies and return the funds to their targeted NAVs, the bank made bailout payments to the funds. It treated the bailout payments as currently deductible expenses, while the funds treated the payments as capital gains that offset the capital losses (causing the NAV deficiencies).

Risk Management Only One Consideration

Although the IRS noted that the taxpayer "was ... concerned about possible lawsuits by fund shareholders if the funds did `break a dollar' [i.e., fall below their targeted NAVs]" it concentrated on the other business purposes behind the taxpayer's establishment of proprietary mutual funds and the bailout payments. Specifically, the Service observed that the taxpayer offered the proprietary funds to preserve its customer base in an environment in Which market share was shifting from traditional insured bank deposits to uninsured investments such as mutual funds. The IRS further determined from the bank's internal memoranda that the bailout payments to the money market funds were largely motivated to preserve the competitive attractiveness of the funds as products for current and prospective investors, who might not otherwise be part of its customer base through traditional insured bank deposits.

The Service analyzed the tax treatment of the bailout payments within the framework of INDOPCO, Inc., 503 US 79 (1992) and other notable capitalization cases. As foreshadowed by the selection of capitalization cases cited and discussed in its analysis, the IRS concluded that the taxpayer was required to capitalize (rather than deduct) the bailout payments:

By transferring $a into the [money market funds] to avoid "breaking a dollar" [the taxpayer] averted potentially disastrous consequences and continued to realize these significant long-term benefits. For instance, [the taxpayer] avoided massive shareholder redemptions and prevented damage to its goodwill and reputation. It also averted potential lawsuits by [the money market funds'] shareholders and by [the taxpayer's] own shareholders. Thus, the transfers prevented the above, helped reduce depositor attrition rates, supported its core retail banking franchise, and protected the substantial profit potential of the funds. Accordingly, the long-term benefits were not merely incidental, but significant...and [the taxpayer] realized the benefits well beyond the year in which the transfer Occurred.

FSA Conflicts with Precedent

The FSA directly conflicts with long-standing industry treatment of bailout payments by investment advisers, which, depending on the facts and circumstances, have generally treated such payments as currently deductible. As indicated in the FSA, the fundamental case in determining whether an expense is a deductible business expense or a capital expenditure is Welch v. Helvering, 290 US 111 (1933). In that case, payments were not deductible as ordinary and necessary expenses, but rather were treated as an outlay for the development of reputation and goodwill and, therefore, were capital expenditures.

Investment advisers contend that bailout payments are distinguishable from the payments in Welch because the taxpayer in Welch "made a capital outlay to acquire goodwill for a new business" (emphasis added); see also Dunn & McCarthy, Inc., 139 F2d 242 (2nd Cir. 1943). In contrast, an investment adviser primarily makes bailout payments to settle or avoid lawsuits (despite the lack of a legal obligation but often with prodding from the filing of a lawsuit), maintain its good reputation with its customers, avoid litigation costs and prevent the loss of earnings that might result from unfavorable publicity. The FSA essentially ignored precedent of both the courts and the IRS that these types of payments generally are deductible expenditures.

For instance, in Pepper, 36 TC 886 (1961), acq. 1966-2 CB 4, the Tax Court reiterated extensive precedent in concluding that "[e]xpenditures by a taxpayer to protect an established business are fully deductible as ordinary business expenses." In response to the Service's contention that the deduction should be disallowed because it was voluntarily made, the court further stated "there is no requirement that there must be an underlying legal obligation to make an expenditure before it can qualify as an ordinary and necessary business expense .... The basic question is whether, in all the circumstances, the expenditure is ordinary and appropriate to the conduct of the taxpayer's business." The FSA makes no mention of Pepper.

A number of additional preINDOPCO cases and rulings support current deductibility of payments made to protect a taxpayer's business reputation. However, more recent cases and rulings suggest that neither the courts nor the IRS (absent the FSA) believe that INDOPCO changed the long-standing precedent that payments made to protect a taxpayer's business are deductible expenses.

Origin-of-claim doctrine

Protecting a business's reputation is only one consideration that the Service and the courts, have examined in addressing the "expense vs. capitalize" issue. In Gilmore, 372 US 39 (1963), the Supreme Court held that the "primary purpose" test is not determinative in certain instances and that the true test of whether an expense should be deductible is the origin and character from which the claim arose (the "origin of claim" doctrine). In Boagni, 59 TC 708 (1973), the Tax Court provided a general rule that settlement payments made under a claim originating in the defense or perfection of title are not deductible; settlement payments made under a claim of the collection of income or the management of property are deductible. Although the IRS provided a lengthy examination of the origin of the bailout payments at issue in the FSA, it apparently did not consider the origin-of-claim doctrine in its analysis.

In contrast to the FSA, in Letter Ruling 9328029, the Service ruled that payments by a taxpayer to settle litigation with his former clients were deductible, because "[t]he origin and character of the claim with respect to which the payments are being made arises (sic) in direct connection with [the taxpayer's] business activities." The facts in Letter Ruling 9328029 are analogous to bailout payments, which are directly connected with or proximately resulting from the business of providing brokerage and investment advisory and related services. The analogy is even stronger if the bailout payments are made to counter allegations that the investment adviser had not properly protected the interests of its customers or clients or to otherwise avoid costly litigation and unfavorable publicity that would adversely affect the investment adviser's business.

The origin and character of the claim for bailout payments arise in direct connection with the ongoing business activities of an investment adviser, and generally do not consist of protecting, defending or promoting a capital asset. Accordingly, the application of the origin-of-claim doctrine has been viewed by investment advisers as permitting bailout payments to be deducted.

Rather surprisingly, the IRS did not contend that the origin and character of the claim with respect to bailout payments resided with the investment advisory agreement between the taxpayer and the fund. Characterizing the investment advisory agreement as the origin of the bailout payments would likely require the capitalization of the bailout payments, because the origin of the claim would be the defense of a capital asset (i.e., the investment advisory agreement itself). However, because the termination of an agreement between an investment adviser and a mutual fund is an extremely uncommon event, it would be inappropriate to conclude that the bailout payments originate with the protection of the agreement rather than the protection of a source of ordinary income for the investment adviser; see, e.g., FMR Corp., 110 TC 430 (1998) (disregarding limited lives of investment advisory contracts in determining presence of long-term benefits because of customary annual renewal of contracts).

Although the Service enumerated a variety of underlying purposes for the bailout payments at issue in the FSA, it clearly underscored the business environment of commercial banks in general (and of the taxpayer in particular) in its analysis. Unclear is the extent to which the maintenance of the bank's "core customer base" with mutual fund offerings and bailout payments to the money market funds was decisive in the IRS's conclusion. However, while often associated with commercial banks and other depository institutions, the concept of a customer base as an asset is not unique to depository institutions and should not necessarily influence the treatment of bailout payments under the origin-of-claim doctrine.

Moreover, the Service did not characterize the bailout payments as either the creation or enhancement of a capital asset under INDOPCO or the protection or defense of a capital asset under the origin-of-claim doctrine. Instead, the IRS concluded that the bailout payments conferred on the taxpayer long-term benefits that required their capitalization under the alternative capitalization requirement of INDOPCO. Also left unclear is the Service's position on the treatment of bailout payments by investment advisers that are not banks.

FROM DAVID MANGEFRIDA, WASHINGTON, DC