Accounting for the costs of package designs.

Accounting for the Costs of Package Designs

Background

On March 6, 1989, the Internal Revenue Service published Rev. Rul. 89-23, Rev. Proc. 89-16, and Rev. Proc. 89-17, providing guidance on the tax treatment of package design costs. These pronouncements generally required capitalization of the costs of all package designs currently in service. Such costs could not be deducted until the package design was abandoned. All previously deducted package design costs had to be added back into income over a period not to exceed six years. Package designs placed in service in taxable years ending after March 6, 1989, were eligible for 60-month amortization, but only if the costs of package designs previously placed in service (which were not eligible for amortization) were included in income.

In response to an overwhelmingly negative reaction to the March 1989 pronouncements, on July 21, 1989 the IRS published Announcement 89-98. Announcement 89-98 delayed the due dates for filing Form 3115 in order to change to a capitalization method of accounting until the transition procedures in Rev. Proc. 89-16 and Rev. Proc. 89-17, requiring capitalization of all previously deducted costs of package designs, could be modified. Accordingly, during the following months, taxpayers incurring package design costs were prohibited from capitalizing and amortizing those costs under Rev. Rul. 89-23. Instead, although knowing that deducting package design costs was an improper method, taxpayers were forced to continue deducting such costs.

On December 18, 1990, 17 months after delaying imposition of the first pronouncements, the IRS issued Rev. Proc. 90-63, revising the guidance relating to accounting for the costs of package designs. Rev. Proc. 90-63 significantly improves the treatment of accounting for the costs of package designs because it permits amortization of the costs of package designs on hand as of the beginning of the year of change. In addition, the revenue procedure provides a limited look-back period during which taxpayers must determine costs that have to be capitalized.

This article analyzes the new revenue procedure and its implication for taxpayers incurring package design costs.

Overview

Rev. Proc. 90-63 establishes procedures for the adoption of alternative methods of amortizing package design costs. The revenue procedure makes available a "pool of costs" method, allowing all package design costs to be accumulated in a single pool and amortized over 48 months. Capitalization of costs on a design-by-design basis with amortization over a period of 60 months, as provided in earlier guidance, also is available. In either case, the method adopted applies to all package design costs, whenever incurred, and not only to costs incurred in certain taxable years.

The revenue procedure provides specific rules for the adoption of the amortization methods. Different rules apply depending upon whether the taxpayer is under examination, at Appeals, or in litigation with the IRS, as well as whether and when the package design issue has been raised by the IRS. Unless the package design issue was raised by the IRS prior to March 6, 1989, taxpayers generally must adopt one of the amortization methods for their first taxable year ending after December 18, 1990.

The revenue procedure is intended by the IRS to provide the exclusive procedures for the adoption of methods to amortize package design costs. Failure to follow the procedures outlined in Rev. Proc. 90-63 could result in the taxpayer's being required to use the capitalization method (described below) and may result in the recovery of package design costs being delayed until their abandonment. In addition, in certain situations a taxpayer may not change its method of accounting for package design costs if the taxpayer has changed, or received permission to change, its method within the past six years.

Package Design Costs

The term package design refers to the specific graphic arrangement or design of shapes, words, colors, pictures, lettering, and so forth on a given product package, or the design of a container with respect to its shape or function. Package design costs generally include the direct and indirect costs associated with package designs. If the taxpayer develops the package design, package design costs include the cost of materials, labor, and overhead associated with the design, including all design exploration and study, refinement of the design, testing, and preparation of the final master comprehensive design. If an independent contractor performs the work, package design costs include all billings related to the development, testing, and preparation of the final master design. If the taxpayer purchases the design, package design costs equal the purchase price.

Identification of the costs to be capitalized is determined under the principles of section 263 for costs incurred before January 1, 1987, and under the principles of section 263A for costs incurred after December 31, 1986, regardless of when the design is placed in service.

Costs that are not related to the package design itself, such as changes to ingredients lists, are not package design costs. In addition, costs associated with coupon inserts, refund offers, or short-lived promotion-related changes are not package design costs.

Alternative Methods of Accounting

for Package Design Costs

Rev. Proc. 90-63 provides three alternative permissible methods for the capitalization and recovery of package design costs. Taxpayers may choose between pool-of-cost capitalization and 48-month amortization, design-by-design capitalization and 60-month amortization, and capitalization. Current expensing of package design costs is not an acceptable method.

1. Pool-of-Cost Capitalization and 48-Month Amortization Method

Taxpayers adopting this method do not associate package design costs with the individual package design asset to which they relate. Instead, all package design costs incurred during the tax year are capitalized and amortized ratably over a 48-month period. A half-year convention is used by treating all package designs incurred during the year as having been incurred on the midpoint of the tax year.

Since costs are not associated with any particular design, the date designs are placed in service or abandoned does not affect the 48-month amortization period. No deduction of the unamortized portion of the costs is allowed for designs never placed in service, or for dispositions or abandonment prior to the end of the 48-month period.

2. Design-by-Design Capitalization and 60-Month Amortization Method

Taxpayers adopting this method must associate package design costs with the individual package design asset to which they relate. Costs of developing (or modifying) designs with either no ascertainable useful life, or a useful life extending beyond the tax year in which the costs are incurred, must be capitalized and amortized ratably over a 60-month period, beginning with the month the design is treated as placed in service. The amortization allowance is determined using a half-year convention by treating the design as placed in service on the midpoint of the tax year. A deduction of the unamortized portion of the basis is allowed for disposition or abandonment of the design before the end of the 60-month period.

3. Capitalization Method

Taxpayers adopting the capitalization method also must associate package design costs with the individual package design asset to which they relate. If the package design asset developed (or modified) with the package design cost has an ascertainable useful life extending beyond the end of the tax year in which the costs are incurred, the taxpayer may amortize the costs ratably over that useful life, beginning with the month the design is placed in service. If the asset developed (or modified) with the package design costs does not have an ascertainable useful life, the taxpayer may deduct the costs only upon the disposition or abandonment of the design.

Establishing an ascertainable useful life for any package design asset is expected to be very difficult. Accordingly, the capitalization method normally should be avoided.

Adoption of Method

A number of automatic procedures are provided for changing a taxpayer's method of accounting for package design costs to a permissible method. The time and manner of adopting the method the taxpayer will use to account for package design costs depends on whether the taxpayer has been contacted for examination, is at Appeals, or is before a federal court. If the taxpayer is under examination or otherwise involved in a controversy with the IRS, the time and manner of adopting the package design cost method may differ depending on whether the package design issue has been raised and, if so, whether it was raised before March 6, 1989 (the date of the original package design guidance). If a taxpayer is involved in a controversy with the IRS on December 18, 1990, the taxpayer's year of change is determined as described below. If on December 18, 1990, there are open years in which the package design issue has been raised, the taxpayer must determine if the issue was raised before or after March 6, 1989. After making that determination, the taxpayer must then comply with the following rules.

Generally, the adoption of a permissible method should be addressed not later than the extended due date of the return for the first taxable year ending on or after December 18, 1990. Should the government raise the package design issue after that extended due date, and the taxpayer has not adopted a permissible method, the permissible methods allowing amortization may not be available.

* Taxpayer not contacted for examination, not at Appeals,

and not before a federal court. Taxpayers that

have not been contacted for examination, are not at

Appeals, and are not before a federal court may adopt

any of the three permissible methods discussed above.

The year of change will be the first taxable year

ending on or after December 18, 1990.

The chosen method of accounting for package design costs is adopted by attaching a completed Form 3115 to a timely filed (including extensions) income tax return for the first year ending on or after December 18, 1990. The Form 3115 may be attached to an amended return, provided that the amended return is filed on or before the date that is 180 days after the beginning of its third tax year ending on or after December 18, 1990. Amended returns for any intervening years also may be required.

Reliance on the ability to use an amended return is not advised. If the taxpayer is contacted for examination after the extended due date for the year of change, but before it has filed the Form 3115, its ability to use an amended return for this purpose is eliminated. If the package design issue then is raised, the taxpayer may be prevented from adopting either of the amortization methods and may be required to use the capitalization method.

* Taxpayer contacted for examination, at Appeals, or

before a federal court, but the package design issue

has not been raised. If a taxpayer has been contacted

for examination, is at Appeals or before a federal

court, but the package design issue has not been

raised, it still may change its method of accounting

for package design costs for the first taxable year

ending on or after December 18, 1990. This is accomplished

by attaching a completed Form 3115 to the

taxpayer's timely filed return (including extensions)

for the year of change. An amended return filed after

the extended due date for that year may not be used.

Thus, receipt of notice of examination cuts off the

taxpayer's ability to adopt a permissible method by

filing an amended return after the extended due date

for the year of change, and may prevent the adoption

of either of the amortization methods.

Procedures also are available for changing from one permissible method to another with the consent of the examining agent, Appeals Officer, or government counsel and for changing during the 120-day period following the issuance of either a letter stating there is no change in tax liability or a basic report form giving notice of the results of the examination, providing package design is not included as an adjustment item or otherwise addressed.

For taxpayers under continuous audit, the taxpayer may change to one of the permissible methods of accounting during the first 30 days of any tax year if the taxpayer has been precluded from changing its method for at least 18 consecutive months prior to the 30-day period, and the taxpayer has not received written notification from the examiner that package design is an issue under consideration prior to the 30-day period.

Each of the special procedures require the year of change to be the first taxable year ending on or after December 18, 1990. Although the special procedures allow any of the three permissible methods to be adopted, their availability can be eliminated if the package design issue is raised before the method change is adopted. Should that occur, the taxpayer may be limited to the capitalization method.

* Taxpayers under examination, at Appeals, or before

a federal court where the package design issue was

raised before March 6, 1989. For a taxpayer under

examination, the year of change is the most recent

tax year under examination, but not later than the

most recent year for which a federal income tax

return has been filed as of the beginning of the

examination. If the examination covers the first

taxable year that an erroneous method of accounting

(any method other than one of the three permissible

methods) for package designs costs is used, however,

the year of change is the year the erroneous

method was first used.

For a taxpayer before Appeals or a federal court, the year of change is the earliest open year in which the issue was raised. If the taxpayer is under examination, before Appeals, or before a federal court for multiple years in which the issue has been raised, the year of change is the earliest of the years in any category.

The change in method of accounting is accomplished by providing the examining agent, Appeals Officer, or government counsel with the original and one copy of a completed Form 3115. The government representative must verify the correctness of the Form 3115, associate the original with the taxpayers federal income tax return for the year of change, and forward the copy to the IRS National Office. If agreement on the correctness of the Form 3115 cannot be reached with the government representative, technical advice may be requested.

* Taxpayers under examination, at Appeals, or before a

federal court where the package design issue was

raised after March 6, 1989. The year of change for

such taxpayers is generally the first taxable year

ending on or after December 18, 1990. The change in

method is accomplished in the same manner as when

the issue had been raised before March 6, 1989.

If the government raises the package design issue after the extended due date of the year of change, and the taxpayer has not adopted a permissible method, the year of change will be the earliest open year under examination, at Appeals, or before a federal court for which the issue has been raised. Further, the only available method in such situations will be the capitalization method. Neither of the methods allowing amortization will be available in such instances.

Section 481 Adjustment

The computation of the section 481(a) adjustment for a change in method of accounting for package design costs varies depending on the method the taxpayer is using subsequent to the change. In addition, the period over which the section 481(a) adjustment is to be amortized is dependent upon whether the taxpayer is using a "permissible" or an "impermissible" method prior to the change.

1. Change to the Pool-of-Cost Capitalization and 48-Month Amortization Method

If a taxpayer is changing to the pool-of-costs method to account for package design costs, the section 481(a) adjustment equals all package design costs deducted or amortized in years prior to the year of change, less the amount that would have been amortized if the pool-of-costs method had been used in such years. It is important to note that abandoned costs are included in prior year costs for purposes of this calculation.

Generally, taxpayers changing to the pool-of-costs method must include the total amount of the section 481(a) adjustment in the calculation of taxable income in the year of change. A taxpayer changing from another permissible method of accounting for package design costs to the pool-of-costs method calculates the adjustment period under Rev. Proc. 84-74.

2. Change to the Design-by-Design Capitalization and 60-Month Amortization Method

If a taxpayer changes to the design-by-design method, the section 481(a) adjustment equals the difference between (i) the total amount of package design costs subject to capitalization and not abandoned as of the beginning of the year of change that were deducted or amortized in tax years before the year of change, and (ii) the amount of amortization that would have been allowed if the design-by-design method had been used.

Generally, taxpayers changing to the design-by-design method must include the total amount of the section 481(a) adjustment in the calculation of taxable income for the year of change. A taxpayer changing from another permissible method of accounting for package design costs to the design-by-design method calculates the adjustment period under Rev. Proc. 84-74.

3. Change to the Capitalization Method

If the taxpayer is changing to the capitalization method of accounting for package design costs, the section 481(a) adjustment will take into account the package design costs subject to the capitalization and not abandoned as of the beginning of the year of change that were deducted or amortized in years prior to the year of change, less the amounts that would have been amortized in such prior years. Amortization allowed in prior years relates only to design costs that had an ascertainable useful life on the date the designs were placed in service. The resulting adjustment is the difference between the basis of the package design costs using the taxpayer's old method and the recomputed basis under the capitalization method.

Generally, the total portion of the section 481(a) adjustment relating to costs incurred after December 31, 1986, is brought into the calculation of taxable income in the tax year of change. The portion of the section 481(a) adjustment relating to costs incurred before January 1, 1987, is included in income over a period not to exceed six years under the rules of Rev. Proc. 84-74.

A taxpayer changing from another permissible method of accounting for package design costs to the capitalization method computes its adjustment period under the rules of Rev. Proc. 84-74.

4. Special Rules

Certain limitations apply to the interaction of the section 481(a) adjustments and net operating losses (NOL) and tax credits. Such rules are set forth in Rev. Proc. 84-74.

Generally, a positive section 481(a) adjustment taken into account in the current year may not be offset by an NOL carryover available at the beginning of the year of change. In addition, any part of a current NOL that is a result of a negative section 481(a) adjustment may not be carried back to the three tax years preceding the year of change.

Income tax credit carryovers available at the beginning of the year of change cannot be used to offset the income tax liability resulting from a section 481(a) adjustment. This general rule does not apply to credits arising in the year of change or carried back from subsequent years.

Summary

Several issues relating to accounting for the costs of package designs have been raised since the publication of Rev. Proc. 90-63.

* While Announcement 89-98 was intended to suspend

compliance with Rev. Rul. 89-23, Rev. Proc. 89-16, and

Rev. Proc. 89-17, that intention was not clearly stated

in the Announcement, and many taxpayers subsequently

attempted to comply with the new rules prior

to 1990. What procedure should such taxpayers utilize

to comply fully with the new provisions? Should

some form of relief be provided for those taxpayers?

* Should a protective election be made by a taxpayer

that does not think it currently has any package

design costs, but is concerned that the IRS may contend

package design costs exist and utilize the capitalization

method?

* Is a taxpayer currently under examination subject to

the same package design audit adjustment agreed to

in closed years for the intervening years until the

taxpayer's year of change?

In order to avoid being forced on the capitalization method by the IRS, taxpayers should voluntarily comply with the procedures provided in Rev. Proc. 90-63 for adopting either the pool-of-costs capitalization and 48-month amortization method or the design-by-design capitalization and 60-month amortization method of accounting for the costs of package designs.

Rev. Proc. 90-63 allows taxpayers until 180 days after the beginning of the third tax year ending on or after December 18, 1990 to file Form 3115 adopting one of the capitalization and amortization methods. Taxpayers taking advantage of this delay, however, are at risk of being forced on the capitalization method if contacted by the IRS for examination and the package design issue is raised prior to their electing one of the capitalization and amortization methods.

ADA S. ROUSSO is a senior manager with Price Waterhouse in Washington, D.C. Prior to joining Price Waterhouse, Ms. Rousso served in the Office of Chief Cousnel with the Intenal Revenue Service. She received a B.A. degree from Russell Sage College, a J.D. degree from The American University, and a LL.M. (Taxation) degree from Georgetown University Law Center. MELBERT E. SCHWARZ is senior manager with Price Waterhouse in Washington, D.C. Mr. Schwarz was previously the Legislation Attorney/Accountant of the Joint Committe of Taxation and a tax accountant with Arthur Young & Co. He is a certified public accountant and a member of both the Texas Bar Association and the Tax Simplification and Efficiency Subcommittee of the Tax Section of American Institute of Certified Public Accountants. Mr. Schwarz holds a B.A. degree from Southern Methodist University, a J.D. degree from the University of Michigan, and a Master of Professional Accounting degree from the University of Texas.