Does Norwest expand INDOPCO's reach?

In Norwest Corp., 112 TC No. 9 (1999), the Tax Court determined that officers' salaries and legal fees incurred by a target company in a friendly acquisition were required to be capitalized, because they were sufficiently related to an event that produced a significant long-term benefit. Taxpayers should not be alarmed with the outcome in this case to the extent it requires the capitalization of a target's consulting fees related to a friendly acquisition, as that determination is consistent with the outcome in INDOPCO, Inc., 503 US 79 (1992). However, taxpayers should be concerned with the outcome in Norwest to the extent it expands INDOPCO's reach by requiring capitalization of otherwise deductible internal costs (i.e., officers' salaries) that would have been incurred notwithstanding the friendly acquisition.

Capitalization and INDOPCO

Sec. 263(a) provides that no deduction is allowed for capital expenditures. Regs. Sec. 1.263(a)-2 provides examples of capital expenditures and includes, among others, the cost of acquiring property with a useful life beyond the tax year. Thus, an expenditure generally must be capitalized under Sec. 263 if it is part of the cost of acquiring a tangible or intangible asset with a useful life greater than one year; see Lincoln Savings and Loan Association, 403 US 345 (1971). These costs are ordinarily recoverable through depreciation or amortization deductions over the asset's useful life. However, if the costs relate to an asset with an unlimited or indeterminate useful life, they may be recovered only on a disposition or cessation of the business.

In INDOPCO, the Supreme Court held that a target corporation undergoing a business restructuring must capitalize its professional fees. Even though the fees did not result in the creation of a separate and distinct asset, capitalization was required, because the expenditure resulted in future benefits to the taxpayer beyond the year in which the expenditure was incurred.

The Norwest Case

In Norwest, the taxpayer was a target company in a friendly acquisition. A portion of the taxpayer's officers' salaries and certain legal fees were attributed to the acquisition. The taxpayer argued that (1) the officers' salaries were ordinary and necessary business expenses (i.e., not capitalizable as part of the acquisition), because the officers' work on the transaction was tangential to their ordinary duties and (2) the legal fees were currently deductible, because they were primarily for "investigatory and due diligence services related to the expansion of its business which, for the most part, were incurred before management decided to enter into the transaction" The taxpayer relied on Briarcliff Candy Corp., 475 F2d 775 (2d Cir. 1973), rev'g and remd'g TC Memo 1972-43, and NCNB Corp., 684 F2d 285 (4th Cir. 1982), in which the courts allowed a deduction for investigation and due diligence costs incurred incident to the expansion of an existing business.

Relying on INDOPCO, the IRS argued (and the Tax Court agreed) that all of the aforesaid costs were required to be capitalized, because the transaction "involved a friendly acquisition from which the parties thereto anticipated significant long-term benefits for the acquired entity." The Tax Court echoed its sentiment, expressed in FMR Corp., 110 TC 402 (1998), that the decisions in Briarcliff and its progeny have been displaced by INDOPCO when expenditures are incurred in similar transactions that do not create a specific asset. This conclusion seems inconsistent with the Service's own position as set forth in Letter Ruling (TAM) 9645002, which was released after INDOPCO and permitted a current deduction for "pre-opening" costs--including the cost of training employees to manage new retail stores.

Norwest's Impact on Deductibility of Target Companies' Professional Fees

The outcome in Norwest, as it relates to the classification of professional fees incurred by a target in a friendly acquisition, is consistent with the outcome in INDOPCO. The general focus for classifying these types of expenditures as deductible or capitalizable remains on whether the target's expenses provided a future benefit to the target (i.e., capitalizable) or were incurred to defend the target's current position (i.e., currently deductible).

Norwest's Impact on Companies Making Acquisitions

For acquiring companies, Sec. 195 carves out an exception to the general rule requiring capitalization of acquisition costs of the stock or other asset basis acquired in a transaction, by allowing "investigatory" costs incurred by an acquirer to be amortized; this exception is not available for target companies. Sec. 195 provides that, at a taxpayer's election, start-up expenditures (excluding interest, taxes or research and development expenditures) may be treated as deferred expenses amortizable over no less than 60 months from the date the taxpayer's trade or business begins. For an acquired trade or business, the business begins on the date of the acquisition. Sec. 195 (c)(1)(A)(i) provides that the term "start-up-expenditure" includes an amount incurred in connection with investigating the creation or acquisition of an active trade or business.

Because the analysis in Norwest focused on the costs incurred by a target company, its outcome is arguably not controlling for classifying expenditures incurred by an acquiring company that qualify as start-up expenditures under Sec. 195. However, it is disconcerting that the Tax Court in Norwest relied on the decision in Ellis Banking Corp., 688 F2d 1376 (11th Cir. 1982), to refute Norwest's argument that when an acquisition expenditure is incurred is critical in determining whether it is deductible (i.e., distinguishing between investigatory costs and costs attributed to an acquisition after a decision to acquire a target is made).

In Ellis Banking, the taxpayer was required to acquire existing banks or organize new banks if it wanted to expand into new geographic markets. Before the acquisition of a particular bank, the taxpayer incurred due diligence costs that it deducted currently. The taxpayer argued that the costs were ordinary and necessary (i.e., deductible under Sec. 162), noting that they were incurred before it was bound to purchase the stock. The Service held (and the Eleventh Circuit agreed) that the expenses were capital expenditures incurred incident to the acquisition of a capital asset.

The outcome in Ellis Banking is arguably not controlling for classifying acquiring companies' investigatory costs; that case was decided on facts and circumstances that arose in years prior to the Sec. 195 effective date and does not address the legislative history of Sec. 195, which recognizes that investigatory costs (in some cases) will not be costs of the capital investment. Additionally, to the extent costs similar to those incurred by the target in Norwest are incurred by an acquiring corporation, the outcome in Norwest is arguably not controlling, because that case dealt only with the costs incurred by a target. However, the IRS has recently asserted that the exception under Sec. 195 for an acquirer's investigatory costs is extremely narrow; see Letter Rulings (TAM) 9901004 (concluding that investigatory costs did not include costs of reviewing a specific target company, but only businesses in general) and 9825005 (the investigatory period ended with a "letter of intent" even though subject to further due diligence review).

Norwest's Impact on the Deductibility of Internal Costs

Perhaps the most alarming outcome in Norwest was the Tax Court's determination that target's officers' salaries related to the acquisition should be quantified and capitalized under INDOPCO. This determination apparently expands the reach of INDOPCO. The taxpayer's argument, that the officers' salaries were part of annual compensation and work related to the acquisition was tangential to the specific duties they were hired to perform, had merit. The argument was supported by the so-called "origin of the claim" doctrine outlined in Gilmore, 372 US 39 (1963). However, reliance on that doctrine, to deduct internal costs related to a capital transaction, was recently weakened by the outcome in Dana Corporation (Fed. Cir. 1999).

The taxpayer in Dana had a history of paying a yearly retainer fee to a law firm to guarantee the availability of the firm's services and to preclude the firm from representing competitors of the taxpayer. The retainer was nonrefundable, but it was creditable against any legal fees the firm charged the taxpayer for services rendered during a particular year. During the year at issue, the retainer fee was credited against legal fees associated with a capital transaction. The taxpayer contended that the retainer fee was an ordinary and necessary business expense, deductible under Sec. 162. The IRS contended that the retainer fee was a nondeductible capital expenditure under Sec. 263, because it ultimately offset legal fees related to a capital transaction.

Relying on Gilmore, the Claims Court reasoned that "[T]he question of whether an expense is deductible turns `upon the origin and nature of the claims themselves'" Citing Gilmore, the Claims Court explained, "`[I]t is the origin of the liability out of which the expense accrues' or `the kind of transaction out of which the obligation arose ... which is crucial and controlling.'" Based on the taxpayer's eight-year history of paying the retainer fees, the Claims Court determined that the fees were an ordinary and necessary business expense under Sec. 162. "The fact that the retainer was later applied to reduce fees associated with a capital acquisition does not relate to the origin of the claimed deduction." Based upon Norwest's history of paying officers' compensation, such expenditures were arguably incurred in the ordinary and necessary business dealings of the company; as such, the salaries were arguably deductible under Sec. 162 (regardless of the activities actually conducted by the officers during the year).

Subsequent to the decision in Norwest, the outcome in Dana was reversed by the Federal Circuit. The Court of Appeals confirmed that the origin of the claim was the proper test for determining the character of the retainer fee and that the retainer agreement was the starting point for the analysis. Under the agreement, the law firm was required to use the retainer fee as a deposit on any services it performed. "This characteristic renders the origin of the claim the actual use of the money to offset fees, and not simply the payment at the start of the tax year of the annual retainer fee. Retainer agreements are ordinary and necessary business expenses, if there is no right of offset ... Thus, the deductibility of the retainer fee must rise and fall with the deductibility of the services for which the retainer fee actually paid." Because the taxpayer capitalized the remainder of the legal fees related to the acquisition, there was no dispute as to whether the fees were deductible as ordinary and necessary business expenses or were nondeductible capital acquisition expenditures. Accordingly, the court held that the retainer fee was nondeductible.

On the surface, it appears the outcome in Dana supports the determination made in Norwest that a target's otherwise deductible officers' salaries, related to a capital acquisition, should be quantified and capitalized. However, a distinction can nevertheless be drawn between the treatment of outside adviser fees and internal officer salaries. In the case of the acquisition services performed in Dana, the law firm was actually "retained" during the year for the specific purpose of providing corporate takeover services. Thus, the Federal Circuit's decision Stands for the proposition that it is not appropriate to analyze the current year's services with reference to the character of prior year services. In contrast, officers are not ordinarily "engaged" each year for particular projects, but have a continuous employment relationship. Therefore, application of the origin of the claim doctrine to officers' salaries arguably leads to a result opposite to that in Dana and Norwest.

Conclusion

Although the outcome in Norwest signals yet another expansion of INDOPCO in the context of a target company's costs, significant doubt still remains as to whether and which internal costs associated with an acquisition should be capitalized. Further, as it deals with the target's (rather than the acquirer's) costs, Norwest should not affect the application of Sec. 195 to an acquirer's investigatory costs.

FROM CAROL CONJURA, J.D., CPA, TIM ZUBER, CPA, MT, WASHINGTON, DC