Proposed guidance on capitalization.

On Jan. 17,2002, Treasury issued an advance notice of proposed rulemaking (ANPRM) (REG-125638-01). The ANPRM describes regulations it expects to provide in 2002, which will help taxpayers distinguish between Sec. 263(a) capital expenditures and currently deductible Sec. 162(a) expenditures incurred in acquiring, creating or enhancing intangible assets or benefits.

The ANPRM (and the forthcoming regulations) is the result of a long-standing controversy over whether capitalizaton is required for intangible assets or benefits. Due to the lack of clarity and detailed guidance under Sec. 263(a) and its regulations, taxpayers had to resolve many disputes on a case-by-case basis, through rulings or court cases. Two landmark Supreme Court cases in this area, decided over 20 years apart, are Lincoln Savings & Loan Ass'n, 403 US 345 (1971), and INDOPCO, Inc., 503 US 79 (1992). In Lincoln Savings, the Court provided that an expenditure is capital if it creates or enhances a "separate and distinct asset." In INDOPCO, however, the Court found that the creation of a separate and distinct asset was not a necessary condition for classifying it as a capital expenditure; rather, the taxpayer had to capitalize expenditures that produced a "significant long-term future benefit." Unfortunately, INDOPCO may have done more harm than good, as the broad nature of the long-term future-benefit test only increased uncertainty, reinforcing the need for additional detailed guidance.

Thus, almost 10 years after INDOPCO, the ANPRM was issued to clarify the long-term future-benefit test by outlining the framework for capitalization issues that the IRS and Treasury expect to provide. The ANPRM is an attempt to provide clear and administrable rules that will significantly reduce uncertainty and controversy in this area, freeing up both IRS and taxpayer resources.

ANPRM Summary

The ANPRM addresses specific types of expenditures for which capitalization is expected to be required, and specifically provides that "[t]he IRS and Treasury Department anticipate that other expenditures to acquire, create, or enhance intangible assets or benefits generally will not be subject to capitalization under section 263(a)." In addition, to reduce administrative and compliance costs, the notice provides safe harbors and simplifying assumptions, including a "12-month rule."

The ANPRM groups expenditures into three main categories, and lists the specific types of costs that fall within each.

Amounts Paid to Acquire Intangible Property. Under the expected regulations, taxpayers will have to capitalize amounts paid to purchase, originate or otherwise acquire a security, option, any other financial instrument described in Sec. 197(e)(1) or any evidence of indebtedness. In addition, amounts paid to another person to purchase intangible property will be subject to capitalization. However, a taxpayer who incurs costs to create its own intangible benefit (e.g., to create a customer base through advertising or other expenditures that create customer goodwill) will not be required to capitalize these costs.

Amounts Paid to Create or Enhance Certain Intangible Rights or Benefits. This category includes seven specific types of costs that will likely require capitalization. However, these costs will be subject to a "12-month rule." Under this simplifying assumption, taxpayers will not be required to capitalize an expenditure unless it creates or enhances intangible rights or benefits that extend beyond the earlier of (1) 12 months after the first date on which the taxpayer realizes the expenditure's rights or benefits or (2) the end of the tax year following the tax year in which the taxpayer incurs the expenditure. For prepaid expenditures, application of the 12-month rule should be fairly straightforward, as the benefit period will be easily ascertainable. However, determining whether taxpayers satisfy the 12-month rule for other types of intangible benefits (e.g., those with no clearly defined benefit period) may be more difficult.

For expenditures not falling within the 12-month rule, taxpayers will have to capitalize:

* Prepayments for goods, services or other benefits;

* Payments for market entry;

* Payments for certain rights granted by a governmental agency;

* Payments for contract acquisition or modification;

* Payments for termination of certain contracts;

* Payments for tangible property to obtain intangible future benefits; and

* Payments for defense or perfection of title to intangible property.

Transaction Costs. With respect to transactions in the first two categories that require capitalization, the ANPRM specifies which types of costs taxpayers will have to capitalize. Generally, transaction costs include costs that facilitate a taxpayer's acquisition, creation or enhancement of intangible assets or benefits previously described. Transaction costs do not include employee compensation (except for bonuses and commissions paid in an acquisition) or fixed overhead (e.g., rent, utilities and depreciation). In addition, taxpayers will be allowed to deduct costs not exceeding a de minimis safe-harbor amount (e.g., $5,000 per transaction).

Treasury is contemplating additional safe harbors and simplifying assumptions, and has requested public comments on the ANPRM. For example, it is considering a rule under which taxpayers could deduct certain transaction costs based on whether they are "regular and recurring" in nature (i.e., incurred in the routine operation of the taxpayer's trade or business). In addition, the rules may allow taxpayers to deduct all employee compensation (including bonuses and commissions paid with respect to the transaction) or provide that the treatment of certain costs will follow financial accounting treatment.

Ramifications 

Although the ANPRM showed the intent of Treasury as to capitalization, it also created uncertainty as to how the issues in this area are to be addressed currently, in light of the fact that the rules are proposed in nature. As a result, the IRS has released internal directives that discuss the implications of the ANPRM on its existing examination and litigation positions.

On Feb. 26, 2002, the IRS issued an internal memorandum to its examiners in the Large and Mid-Size Business and Small Business/Self-Employed Divisions. The memorandum reiterates that the rulings and standards in the ANPRM are not IRS positions and do not give examiners authority to concede issues. Further, proposals on administrative safe harbors and simplifying assumptions are merely proposals and not standards to be used in resolving existing cases. However, the memorandum expressly addresses the proposed 12-month rule, and notes that Treasury and the IRS will likely adopt it in the final regulations. Thus, the memorandum recommends that when determining whether to propose capitalization of short-term expenditures, examiners should pursue the issue for ongoing examinations in which a notice of proposed adjustments or a Revenue Agent's Report was issued, but not pursue examinations for which neither of those forms was prepared.

In addition, on March 15, 2002, the IRS issued Chief Counsel Notice 2002-021, which announced a change in the IRS'S litigating position on capitalization of transaction costs for the acquisition, creation or enhancement of intangible assets. According to the notice, in light of the ANPRM, the IRS will not assert that certain transaction costs must be capitalized under Sec. 263(a). According to the notice, the IRS has concluded that "it is an inefficient use of resources to litigate certain transaction cost issues while in the process of proposing regulations that may ultimately allow a current deduction for such costs. Accordingly, until further guidance is finalized, the Service will not assert capitalization under section 263(a) for employee compensation (other than bonuses and commissions that are paid with respect to the transaction), fixed overhead or de minimis costs [i.e. $5,000 per transaction] related to the acquisition, creation or enhancement of intangible assets or benefits."

FROM CATHY FITZPATRICK, CPA, MST, WASHINGTON, DC