Comments on proper treatment of package design costs, June 20, 1989.

               Comments
                  on

Proper Treatment of Package Design Costs

June 20, 1989

On behalf of the Tax Executives Institute, I want to thank you for meeting with us on June 12 to discuss the recent ruling and procedures in respect of package design costs.

Although the Institute continues to question the propriety of Rev. Rul. 89-23 and whether it should be given any retroactive effect, we are pleased that the IRS is moving toward providing transitional relief in respect of the implementation of the package design ruling and revenue procedures. In this letter, we summarize our understanding of the changes now under consideration in the National Office and comment on some implementation issues that we believe could benefit from further consideration.

Proposed General Rule

Perhaps the most profound implementation issue posed by the IRS's package design ruling and revenue procedures is the so-called 1913 issue - the requirement of Rev. Proc. 89-16 that taxpayers reconstruct package design costs incurred potentially as far back as 1913. Based on our discussion, consideration is being given to providing that taxpayers who make a section 481 adjustment under Rev. Proc. 89-16 need go back only a limited number of years (say, to the later of 1984 or the taxpayer's earliest open year) and undertake to capture package design data.

TEI is heartened by indications that the IRS will soon take amelioratory action in respect of the implementation of Rev. Rul. 89-23. Limiting the section 481 "look-back" to five (or fewer years(*)) would not only be symmetrical with the capitalization period allowed by Rev. Proc. 89-17 (in respect of post-March 6, 1989, package design costs), but would also give recognition to the tremendous administrative burdens otherwise posed by Rev. Proc. 89-16. We also believe it would be consistent with general principles underlying section 7805(b) of the Code. Those principles could be further vindicated, however, if taxpayers were permitted to amortize the amount required to be capitalized in each of the years during the applicable section 481 spread period.

"Mass Asset" Election

TEI is especially pleased with IRS's efforts to perfect a "mass asset" alternative to the capitalization and amortization rules set forth in Rev. Proc. 89-17. Under such an elective procedure, taxpayers would "pool" all the costs incurred in respect of package designs and amortize those costs over a specified time period, without regard to whether any of the designs had a useful life of less than the specified period or whether any of the designs were abandoned before the expiration of that period.

As illustrated during our June 12 meeting, in adopting the mass asset approach, taxpayers would be required to make a section 481 adjustment, but the section 481 look-back period would be limited (as under the proposed general rule). Significantly, however, taxpayers would be permitted to amortize the amount required to be capitalized under section 481 and that amount would be reduced by the amount of package design costs that would have been amortized had a mass asset election been in effect during the affected years. For example, assuming a five-year amortization period, if a taxpayer incurred $100 of package design costs in the second year preceding the year of change, only $60 would have to be capitalized in the year of change (since $20 would have been amortized in the first and second years preceding the year of change) and $20 of the capitalized $60 would be amortized in the year of change, with the remainder being amortized in the succeeding two years ($20 in each year).

TEI believes that a mass asset approach would obviate the need for the taxpayer to keep records on a package-by-package basis. Perhaps more important, it would also eliminate the need to determine what constitutes an abandonment of a package design (as compared to an insubstantial modification).

Open Issues

As we discussed, one of the issues that needs to be addressed is whether, because a design-by-design application of the deemed useful life rule would not be available, the mass-asset amortization period should be shorter than the 60-month period allowed under Rev. Proc. 89-17. We suggest that providing a shorter amortization period would be an appropriate way to induce taxpayers to elect the mass asset alternative (thereby minimizing potential audit disputes to taxpayers' and the IRS's common benefit). In addition, consideration should be given to whether taxpayers making a mass asset election should be permitted a "spread" of the section 481 adjustment comparable to that allowed under the general rule.

Another issue is how the section 481 adjustment should be computed where a taxpayer has accepted a substantive result identical to that in Rev. Rul. 89-23 and Rev. Proc. 89-17 (e.g., capitalization and amortization of package design costs over a 60-month period) but has not formally changed its method of accounting. Such a situation could arise in respect of an Appeals Division settlement, where the taxpayer has accepted a capitalization adjustment but has not filed a Form 3115. As you stated at the beginning of the meeting, one of the goals of the IRS's implementation policy should be to ensure that taxpayers are not penalized for having "come on board" before the issuance of the ruling and revenue procedures.

A third issue is the distinction between design graphics and design structure. Although we agree that the IRS should move expeditiously in providing transitional relief (especially in light of the September 2, or October 2, deadline set forth in Rev. Proc. 89-16), we believe there are fundamental differences between "graphics" and "structure" that should be recognized in implementing Rev. Rul. 89-23. In particular, where a taxpayer has capitalized "structural" package design costs and amortized those expenses over a three-year period (as falling within the same depreciation class as molds and dies), we do not believe it would be appropriate to require the taxpayer to "recapture" any portion of the amortized costs in computing its section 481 adjustment. A similar question exists, moreover, with respect to the period over which post-March 6, 1989, "structural" design costs should be amortized.

Once again, TEI appreciated the opportunity to meet with you, Irwin Lieb, and Bob Testoff to discuss our policy and implementation concerns in respect of the package design cost issue. If we can be of any assistance as the IRS moves ahead on this project, please do not hesitate to let us know. In this regard, I suggest you coordinate with either Timothy McCormally or Mary Lou Fahey at TEI Headquarters (638-5601). As we discussed during our meeting, given the major changes in the Code's capitalization rules effected by section 263A, we believe a January 1, 1987, effective date can be justified.

(*) As we discussed during our meeting, given the major changes in the Code's capitalization rules effected by section 263A, we believe a January 1, 1987, effective date can be justified.