The final INDOPCO regulations: a primer.

Twelve years after the Supreme Court's landmark (or nefarious, depending on your perspective) decision in INDOPCO, Inc. v. Commissioner, (1) the Treasury Department and the Internal Revenue Service have issued final regulations attempting to put the "significant future benefit" genie back in the bottle. The regulation represents a policy-level response to what many had perceived to be zeal on the part of some IRS field personnel in applying the Court's "significant future benefits" standard and, in many respects, represents a sea change in the government's traditional perspective on capitalization. This article provides an overview of the new regulations and offers insights into their development and likely implications.

The Road Here

The road from the Supreme Court's 1971 decision in Lincoln Savings & Loan (2) to its 1992 decision in INDOPCO, as well as the tumultuous aftermath of that later decision, is heavily documented and need not be recounted here in detail. In Lincoln Savings, the Supreme Court required a financial institution to capitalize payments made to a government-administered insurance fund where the financial institution had a continuing property interest in the fund. The Supreme Court required capitalization on the grounds that the payments created a separate and distinct asset having a useful life extending substantially beyond the end of the taxable year. (3)

Courts diverged in their interpretation of Lincoln Savings, with some reading the case to mean that an expenditure had to be capitalized only if it gave rise to a separate and distinct asset, (4) while other courts (and the IRS) interpreted Lincoln Savings to mean only that the creation of a separate and distinct asset is one--but not the only--basis for capitalization. (5) The Supreme Court in INDOPCO confirmed that the second interpretation is correct. In explaining its holding, the Court said that creation of a separate and distinct asset is a sufficient but not necessary predicate to capitalization. Capitalization also may be required where the costs give rise to a significant future benefit. (6)

The IRS National Office took the position that INDOPCO did nothing more than clarify what had been the applicable law all along and that a cost that was not capitalizable before INDOPCO was not capitalizable solely by reason ofINDOPCO. (7) Nonetheless, there was at the very least a perception that IRS field agents read INDOPCO as creating a new category of capitalizable costs. (8) In public remarks, senior IRS and Treasury officials downplayed this perception, suggesting the increase in capitalization issues was due in part to the changing nature of the American economy and the emergence of an increasing array of intangibles that had never before been scrutinized under section 263. (9) Nonetheless, the perception persisted.

Whether in response to the emergence of a new generation of intangibles that did not fit neatly within the decades old template of capitalization principles, its string of losses before appellate courts permitting deductions for an array of costs, (10) or the continuing perception of revenue agents gone wild, the National Office and Treasury committed to issue regulations fundamentally changing the capitalization landscape. The resulting final regulations were published in January 2004. (11)

The Regulations

The final INDOPCO regulations appear as Treas. Reg. [section] 1.263(a)-4, applicable to costs incurred to acquire or create intangibles, and Treas. Reg. [section] 1.263(a)-5, applicable to costs incurred to facilitate the acquisition of a trade or business, a change in the capital structure of a business entity, and certain other transactions. The two sections share a number of similarities, but are best considered separately.

Acquisition or Creation of Intangibles

The analysis underlying Treas. Reg. [section] 1.263(a)-4 essentially follows three steps: (a) what intangibles fall within its scope; (b) what activities with respect to those intangibles require capitalization; and (c) what costs relating to those activities must be capitalized.

a. Which Intangibles?

The final regulations require capitalization of (i) an amount paid to acquire any intangible; (ii) an amount paid to create certain but not all intangibles; (iii) an amount paid to create or enhance a "separate and distinct intangible asset"; and (iv) an amount paid to create or enhance a "future benefit," but only under certain circumstances.

Two extremely important concepts are embedded in this section. The first is the government's use of a narrow definition of "separate and distinct intangible asset," presumably to prevent expansive interpretations of the Lincoln Savings "asset" concept as a means around the regulations' constriction of the INDOPCO "significant future benefit" standard. The final regulations define a "separate and distinct intangible asset" as a property interest of ascertainable and measurable value in money's worth that is subject to protection under applicable state, federal, or foreign law, and the possession and control of which is intrinsically capable of being sold, transferred, or pledged separate and apart from a trade or business. Critically, the final regulations define "separate and distinct intangible asset" as a property interest containing each of these characteristics, rather than stating the characteristics as simply factors to consider in determining whether an intangible rises to the level of an asset. Although courts have considered each of these factors at various times in identifying a potential asset, this tripartite definition changes the substantive law defining an "asset," at least for this one purpose. In doing so, Treasury and the National Office converted what had been a facts-and-circumstances inquiry into a concrete definition with clearly defined boundaries, substantially less susceptible of creative or expansive interpretations.

Perhaps tacitly acknowledging the purpose behind this restrictive definition, IRS officials have indicated informally that they do not plan to extend it to other situations requiring the identification of an asset, such as the forthcoming repair regulations. (12) This is unfortunate, because a single, unified definition of "asset" for all purposes of the capitalization rules--including the repair regulations as well as the uniform capitalization rules (13)--would further the goal of simplification.

The second critical concept embedded in this section is the government's imposition of rigid controls on the use of the significant future benefit standard. The regulations require taxpayers to capitalize costs incurred to create or enhance a "future benefit identified in published guidance in the Federal Register or the Internal Revenue Bulletin ... as an intangible for which capitalization is required under this section." The practical effect of this provision is to retain the Supreme Court's "significant future benefit" standard, but to place control of that standard squarely within the purview of the senior leadership of the IRS and Treasury. Because nothing can be published in either the Federal Register or the Internal Revenue Bulletin without the concurrence of the Assistant Treasury Secretary (Tax Policy), the Commissioner, and the IRS Chief Counsel, no cost can now be capitalized under the significant future benefit standard unless (i) it is specifically identified in the final regulations as a capital expenditure, or (ii) the Assistant Secretary, the Commissioner, and the Chief Counsel all agree that the purported future benefit is in fact significant enough to require capitalization. This determination can no longer be made by revenue agents, branch-level attorneys within the National Office (such as through a technical advice memorandum), or other subordinate IRS personnel.

Moreover, even if a new significant future benefit is identified in published guidance, the guidance will apply prospectively only. (14) This assurance will prevent unpleasant surprises during the examination process. The policy-level containment of the significant future benefit standard, along with the creation of the new presumption of deductibility for self-created intangibles (discussed below), was the government's primary means of putting the significant future benefits genie back in the bottle.

The regulations rely heavily upon lists and examples rather than broad principles. For instance, the final regulations apply to the acquisition or creation of "intangibles." This key concept is left undefined, however, with its meaning derived only by reading the lists, categories, and examples in which the term appears. As a second illustration, the preamble explains that in order to avoid potential ambiguities or uncertainties regarding the meaning of the word "enhance," the final regulations delete the concept in favor of identifying specific circumstances involving capitalizable "enhancements" (such as upgrades in a membership). Again, rather than invite ambiguity or permit creative interpretations, the government chose to eliminate the concept altogether and to replace it with specific situations requiring capitalization. The regulations' heavy reliance on lists, specific categories, and detailed examples suggests that rather than invite another round of controversy on the proper interpretation to be given to a new set of general principles, the government chose to simply tell agents and taxpayers the specific costs that are to be capitalized.

b. Which Activities?

Treas. Reg. [section] 1.263(a)-4 applies only to costs incurred to acquire any or to create some intangibles. Treas. Reg. [section] 1.263(a)-4(c) requires taxpayers to capitalize costs incurred in connection with the acquisition of a laundry list of intangibles, including, for example, an ownership interest in a corporation, partnership, or LLC; a variety of financial interests and products; insurance and annuity contracts; leases; patents and copyrights; as well as both "customer-based" and "supplier-based" intangibles. This list is not exclusive, and taxpayers instead must capitalize any amount paid to another party to acquire any "intangible" from that party in a purchase or similar transaction. For the most part, Treas. Reg. [section] 1.263(a)-4(c) breaks little new ground.

The truly groundbreaking aspect of the final regulations appears in the rules applicable to costs incurred to create an "intangible." Treas. Reg. [section] 1.263(a)-4(d) provides an exclusive list of eight categories of items that must be capitalized as creating an intangible. If an item or activity does not fall within one of these eight categories, the costs are deductible. (14A) This is a dramatic departure from the traditional view of deductions as being a matter of legislative grace and available only to the extent specifically provided. (15) The IRS previously had looked to INDOPCO itself as support for the proposition that "capitalization is the norm." (16) Instead, at least with respect to self-created intangibles, the final regulations reverse the government's long-held position and establish deductibility as the default rule.

(1.) Financial Interests. Taxpayers must capitalize the costs of creating, originating, entering into, renewing, or renegotiating five specific types of financial interests: (i) ownership interests in certain entities (e.g., stock and partnership interests); (ii) intangibles treated as debt for tax purposes; (iii) a financial instrument (e.g., a credit card agreement, a notional principal contract, a futures or forward contract (including a "take or pay" contract), or any derivative); (iv) an endowment contract, annuity contract, or an insurance contract that has cash value; and (v) nonfunctional currency. Taxpayers also must capitalize the costs of creating an agreement providing either party with the right to use, possess, or sell one of the listed financial interests.

(2.) Prepaid Expenses. Taxpayers must capitalize the costs of prepaid expenses, such as prepaid insurance and prepaid rent. The regulations' new 12-month rule, however, generally will allow taxpayers to continue deducting prepayments of no more than 12 months (providing the amounts are otherwise properly accrued under the economic performance rules).

(3.) Certain Memberships and Privileges. Taxpayers must capitalize costs to obtain, renew, renegotiate, or upgrade a membership or privilege. For example, costs paid by a doctor to a hospital for lifetime staff privileges must be capitalized. Any annual renewal costs, however, should remain deductible by reason of the new 12-month rule. Costs incurred for product ratings or certifications (such as ISO 9000 costs or costs to acquire an Underwriters Laboratory certification) remain deductible. (17)

4. Certain Rights Obtained From a Government Agency. Taxpayers also must capitalize costs paid to a government agency to obtain, renew, renegotiate, or upgrade its rights under a trademark, trade name, copyright, license, permit, franchise, or similar right granted by that governmental agency. Examples include business licenses, liquor licenses, taxi medallions, broadcasting licenses, and the costs of bar admissions. Again, however, one-year licenses or renewals should remain deductible under the 12-month rule.

5. Certain Contract Rights. Taxpayers must capitalize amounts paid to another party to create, originate, enter into, renew or renegotiate a contract providing the taxpayer with the right either to use or to be compensated for the use of property; the right to either provide or receive services; a covenant not to compete; a stand-still agreement; or an insurance policy, endowment, or annuity. Capitalization is not required where the contract provides only a hope or expectation of patronage, nor where the agreement can be cancelled at-will within the first year.

Significantly, capitalization is only required where the taxpayer obtains some form of assurance of a future income stream or of a concrete, commercial benefit. The intended distinction is between contracts having a guaranteed benefit of some commercial value versus (for example) "best efforts" contracts providing only a speculative benefit. (18) Where there is no certainty of a future income stream, there is no basis for "matching" the costs using the capitalization rules.

Unlike the seven other categories of costs relating to the creation of intangibles, costs of creating a contract are eligible for a $5,000 per transaction de minimis rule. Under this rule, so long as the costs of creating the contract are no more than $5000, they may be deducted regardless of the duration of the contract. Property (such as a cell phone provided to new customers) is valued at its fair market value at the time of payment. The rule is a "cliff," such that if the total costs exceed $5000, the entire amount must be capitalized. Although the de minimis rule generally applies on a contract-by-contract basis, the final regulations provide a "pooling" or averaging mechanism for groups of 25 or more similar contracts created during the year.

6. Contract Terminations. Taxpayers also must capitalize costs paid to another party to terminate (i) a lease of real or tangible personal property (under which the taxpayer is lessor); (ii) an agreement granting the party the exclusive right to acquire or use the taxpayer's property or services or to conduct the taxpayer's business; or (iii) an agreement that prohibits the taxpayer from competing with that party or from acquiring property or services from a competitor of that party. As with the costs of acquiring a contract, the key here is that the taxpayer acquires something of commercial value in exchange for the payment. The value may be in the form of reacquiring the right to use property previously subject to a lease; the right to operate within a previously unavailable territory; or the right to conduct business with additional parties. In each case, the payment produces a distinct and identifiable legal right or entitlement having some commercial value.

7. "Kauai Terminal" Payments. The final regulations require taxpayers to capitalize amounts paid for real property if the taxpayer transfers ownership of the real property to another person (except to the extent the real property is sold for fair market value) and the property reasonably can be expected to confer significant economic benefits upon the taxpayer after the transfer. For example, if the taxpayer incurs costs to build a bridge, a highway overpass, a "curb cut," a railroad spur, or similar real property to which it does not retain title, the taxpayer must capitalize the costs if the real property will significantly benefit the taxpayer's own trade or business. (19) The regulations' drafters frequently refer to this as the "Kauai Terminal" rule, after the Board of Tax Appeals decision presenting the model fact pattern. (20) Unlike the proposed regulations, the final regulations do not apply this rule to personal property.

8. Defense or Perfection of Title to Intangible Property. Finally, taxpayers must capitalize amounts paid to another party to defend or perfect title to intangible property if the other party challenges the taxpayer's title to the intangible property. The government seemingly viewed this as nothing more than an affirmation of a well-settled and non-controversial principle.

In summary, the final regulations require taxpayers to capitalize the costs of acquiring any "intangible" but to capitalize the costs of creating only an intangible specifically identified in one of these eight categories. The regulations note, however, that the government will liberally construe the scope of these categories to ensure that taxpayers do not attempt to support a deduction merely by changing the label placed on an otherwise capital expenditure. This well-intentioned warning to creative taxpayers ideally will not encourage revenue agents to take an over-expansive view of the eight categories, thereby simply shifting the capitalization debate to a discussion of the boundaries of these categories.

c. Which Costs?

Once a taxpayer has determined that it has either acquired or created an intangible within the scope of the regulations, the remaining task is to identify those costs subject to capitalization. Thankfully, Treas. Reg. [section] 1.263(a)-4 does not follow the style of the uniform capitalization regulations. (21) Instead, the new INDOPCO regulations provide a set of relatively straightforward rules laced with a number of new simplifying conventions that should significantly reduce the administrative and compliance burdens previously faced by taxpayers and the government. First, Treas. Reg. [subsection] 1.263(a)-4(c) and (d) contemplate the capitalization of the principal costs incurred in acquiring or creating intangibles, as determined under other existing authority, including case law and section 263A.

The only real discussion of which of these principal costs must be capitalized appears in the form of two exceptions. First, the regulations create a $5,000 de minimis rule applicable to the costs of creating certain contract rights. Second, and of broader interest, the regulations create a new 12-month rule.

Under this rule, taxpayers need not capitalize the costs of creating an intangible whose benefit will not extend be yond the earlier of (i) 12 months or (ii) the end of the taxable year following the year in which the payment is made. The rule was structured in this manner to ensure that taxpayers could not prepay an expenditure whose benefit would reach beyond the succeeding calendar year. For example, if a taxpayer prepays a 12-month insurance contract in December 2004, but the policy does not take effect until February 2005, the benefit of the payment would last until February 2006. While the government could look to Rev. Proc. 71-21 (22) as precedent for allowing a limited mismatch of income and expense in the interest of simplification, the government apparently was concerned about creating a pure 12-month rule that in a situation like this could stretch the benefits into a third year.

Similarly, the government did not want to simply allow a deduction any time the benefit did not extend beyond the end of the next taxable year. Doing so would have created a "24-month rule" under which a taxpayer could, for example, prepay an amount in January 2004 having a benefit lasting until December 2005. The government was unwilling to apply the "significantly beyond the end of the taxable year" standard quite so liberally. Accordingly, the regulations' new 12-month rule became a two-prong test.

Apart from its two-prong structure, the new rule essentially is the IRS's acknowledgement that the 12-month rule previously applied by the Seventh Circuit in U.S. Freight-ways (23) is a proper method of accounting that clearly reflects a taxpayer's income. Interestingly, the IRS continues to reject the validity of a 12-month rule for years before the effective date of the final regulations and has begun denying pending requests to change to a method of accounting using a 12-month rule where the changes were filed for prior years under the authority of U.S. Freightways. It is unclear how a 12-month rule did not clearly reflect income under the common law, but suddenly does clearly reflect income simply by reason of the final regulations. Clear reflection should be the guiding principle where taxpayers otherwise comply with the requirements of section 446(e) in requesting IRS consent to change accounting methods.

The new regulations provide a number of special rules to help taxpayers determine whether a contract has a useful life of more than 12 months. Contract rights of an "indefinite duration" are ineligible, as are contracts that have a reasonable expectancy of being renewed beyond the end of the 12-month period. Although a "reasonable expectancy of renewal" largely is a factual inquiry, the new regulations provide a number of guidelines for making this determination. The regulations also allow the taxpayer to use a "pooling" or averaging mechanism to determine whether 25 or more similar contracts created during the year are reasonably expected to be renewed, rather than making that determination on a contract-by-contract basis.

Although valuable to the extent it applies, the 12-month rule remains inapplicable to a large number of transactions. First, it applies only to costs to create intangibles, and is inapplicable to any costs incurred to acquire an intangible. Second, it does not apply to the costs of creating financial interests, including insurance contracts, nor to costs of creating an intangible that constitutes an "amortizable section 197 intangible." (24) Finally, the 12-month rule cannot be used to support a deduction for an amount that has not otherwise satisfied the standards of section 461, including the economic performance rules. (25)

Apart from the 12-month rule and the de minimis rule for the costs of creating certain contracts, the final regulations' primary focus in identifying the costs subject to capitalization is upon transaction costs. The regulations require taxpayers to capitalize costs incurred to "facilitate" the acquisition or creation of intangibles. Expanding the definition contained in the proposed regulations, the final regulations define "facilitate" as paid in the process of investigating or otherwise pursuing the transaction. Although this necessarily is a facts-and-circumstances test, the final regulations retreat somewhat from the proposed regulations by providing that whether an expenditure would have been incurred "but for" the transaction is a relevant but not determinative consideration. The proposed regulations had provided that such a "but for" inquiry would not be relevant; IRS executives have informally defended the reintroduction of this "but for" concept on the grounds that, because the analysis is a factual one, there is no reason to eliminate any relevant facts. Nonetheless, use of a "but for" standard, even as only one of several factors, invites controversy between taxpayers and the IRS over how attenuated a cost can be from the core transaction and still have been incurred in the process of pursuing that transaction. The reintroduction of a historically problematic inquiry somewhat undermines the regulations' stated goal of simplification and elimination of controversy.

Otherwise, the final regulations' treatment of transaction costs is largely taxpayer favorable and contains a number of provisions to reduce controversy. For example, the regulations provide a relatively clear starting point for capturing transaction costs relating to the creation of certain financial interests and contracts. A cost does not facilitate the creation of these intangibles if it relates to activities performed before the earlier of the date the taxpayer begins preparing a bid or begins discussions with the other party. Although this date is earlier (and thus requires the capitalization of more transaction costs) than that applicable to "covered transactions" under Treas. Reg. [section] 1.263(a)-5, it nonetheless provides a starting point helpful in managing the effects of the resurrected "but for" test.

Second, the final regulations create a bright-line rule permitting a deduction for all overhead and employee compensation costs, including payments to independent contractors in certain circumstances. Although a blanket deduction for all such costs is seemingly inconsistent with the Supreme Court's decision in Idaho Power, (26) it follows more recent appellate opinions in PNC (27) and Wells Fargo (28) in permitting a deduction for costs incurred in the routine operation of the taxpayer's daily business. The preamble explains that while the government was sympathetic to taxpayer requests for a rule permitting a deduction for "regular and recurring" business expenses, it was unable to devise a workable definition or set of principles for that concept. Instead, because most costs typically thought of as being "regular and recurring" can broadly be described as either overhead or employee compensation, permitting a blanket deduction for these two categories was seen as an adequate substitute. Although questionable from a technical perspective, this rough justice should go a long way toward eliminating needless controversies and the frequently burdensome recordkeeping otherwise required to support deductions for what most acknowledge to be routine business expenses.

Third, the final regulations provide an additional de minimis rule for transaction costs not exceeding $5,000 per transaction. As with the de minimis rule for contract creation costs, this rule is wholly inapplicable if the aggregate transaction costs on a transaction exceed $5,000. Taxpayers may use a "pooling" mechanism to determine the average transaction costs incurred with respect to 25 or more similar transactions occurring during the taxable year. Curiously, however, the de minimis rule does not apply to commissions paid to facilitate the acquisition or creation of a number of financial instruments, including stock, debt, and insurance contracts. This limited carve out from an otherwise blanket rule creates a number of unfortunate anomalies. For example, while a taxpayer may deduct internal commissions of any amount on the acquisition or creation of an insurance policy under the general exclusion for employee compensation, it would be unable to do so if it hired a third party to perform the same task. Similarly, while commissions up to $5,000 paid to a third-party for signing up new cellular telephone customers would be deductible under the de minimis rule, commissions of any amount paid to the same third-party for signing up new credit card customers would be capitalized. The interaction of these rules creates a distinction in the treatment of commissions paid to internal and external sales personnel on identical transactions, as well as a distinction between taxpayers engaged in transactions involving financial products versus all other types of intangibles. A question arises whether this scheme is consistent with Treasury's stated goal of simplification.

Effective Date and Transition Issues

Treas. Reg. [section] 1.263(a)-4 is effective for costs paid or incurred on or after December 31, 2003. Taxpayers whose current method of accounting does not conform to the new rules are provided with automatic consent to change to a method consistent with the new rules. The IRS recently issued Rev. Proc. 2004-23 (29) setting forth the special procedures that must be followed in making a method change pursuant to the new regulations. The revenue procedure's automatic consent provisions are available only with respect to the taxpayer's first taxable year beginning on or after December 31, 2003. The IRS has indicated it will issue additional guidance for later years.

Rev. Proc. 2004-23 provides special procedures applicable to these method changes in lieu of the generally applicable automatic consent provisions of Rev. Proc. 2002-9. (30) Taxpayers that have already filed a method change request falling within the scope of but not complying with the requirements of Rev. Proc. 2004-23 must either re-file the request or, alternatively, submit supplemental information. As a condition of obtaining automatic consent under Rev. Proc. 2004-23, certain taxpayers that previously changed without IRS consent to a method of accounting now permitted by the final regulations must file amended returns returning to their historic accounting method for years prior to the effective date of the final regulations. This requirement, however, largely applies only to taxpayers who "jumped the gun" in seeking to change methods in anticipation of the final regulations.

The final regulations and Rev. Proc. 2004-23 provide that the section 481(a) adjustment for an accounting method change made to comply with Treas. Reg. [section] 1.263(a)-4 for a taxpayer's first taxable year ending on or after December 31, 2003, is determined by taking into account only amounts paid or incurred in the taxable years ending on or after January 24, 2002 (the publication date of the ANPRM). The effect of this modified section 481 adjustment is the same as if the government had imposed a cut-off method as of January 1, 2002. Any costs incurred before that date that would have been deductible under the final regulations, but which a taxpayer capitalized in accordance with the government's prior positions (such as its prior rejection of a 12-month rule or deductions for package design costs), will remain capitalized by reason of their exclusion from the section 481 calculation. Oddly, Rev. Proc. 2004-23 provides that the section 481(a) adjustment includes amounts incurred in 2002 as well as in 2003, even though 2003 will be the year of change. Typically, the section 481(a) adjustment includes only amounts incurred as of the beginning of the year of change.

The preamble to the final regulations indicates that the IRS received many Forms 3115 requesting to change methods of accounting in reliance on the NPRM. In Rev. Proc. 2004-23, the IRS indicated that taxpayers that filed requests for years prior to the effective date of the final regulations may withdraw the request and receive a refund of the user fee. Requests that are not withdrawn will be processed in accordance with applicable procedures governing tentatively adverse rulings. The practical result is that a taxpayer can receive automatic consent under the authority of the final regulations to change to an accounting method applying a one-year rule or deducting package design costs (for example) for its first taxable year ending on or after December 31, 2003. Taxpayers with pending requests to use the identical methods beginning in earlier years under the authority of cases decided unfavorably to the IRS (e.g., U.S. Freightways and RJR Nabisco (31), however, will have their requests denied. Taxpayers may contest the National Office's denial of consent to make these method changes in earlier years through published administrative procedures and even through litigation (challenging the denials as an abuse of discretion). Given that automatic consent is available beginning in 2003, however, it remains to be seen whether any taxpayers have factual situations justifying the expense entailed in doing so.

Business Acquisitions, Restructurings, and Recapitalizations

Unlike the proposed regulations, the final regulations include a separate section--Treas. Reg. [section] 1.263(a)-5--requiring taxpayers to capitalize costs incurred to facilitate an acquisition of a trade or business, a change in the capital structure of a business entity, and certain other transactions. Unlike Treas. Reg. [section] 1.263(a)-4, this section applies only to transaction costs--costs that "facilitate" the business acquisition--and is inapplicable to the principal costs incurred in acquiring the trade or business. In focusing on transaction costs, Treas. Reg. [section] 1.263(a)-5 uses the same definition provided in Treas. Reg. [section] 1.263(a)-4, namely costs incurred in the process of investigating or otherwise pursuing the transaction, including costs to value or to place a price upon the trade or business. Also like Treas. Reg. [section] 1.263(a)-4, this section uses a limited "but for" test, under which the fact that a cost would not have been incurred "but for" the underlying transaction is relevant but not determinative.

Treas. Reg. [section] 1.263(a)-5 applies to a broad but presumably exclusive list of corporate transactions. Specifically, the new rules require the capitalization of transaction costs relating only to the following ten types of transactions: (i) an acquisition of as sets constituting a trade or business; (ii) the taxpayer's acquisition of an ownership interest in a business entity if the two are related immediately thereafter; (iii) another party's acquisition of an ownership interest in the taxpayer; (iv) a restructuring, recapitalization, or reorganization of the capital structure of a business entity (including reorganizations described in section 368 and section 355 transactions); (v) a section 351 or section 721 transaction; (vi) the formation or organization of a disregarded entity; (vii) an acquisition of capital; (viii) a stock issuance; (ix) a borrowing; or (x) writing an option. (32)

The final regulations significantly modify the scope of the NPRM to eliminate distinctions between tangible and intangible assets acquired in connection with a trade or business. The proposed regulations applied only to intangible assets acquired as part of a trade or business but not to amounts paid to acquire (or to facilitate the acquisition of) tangible assets. The result was that the simplifying conventions for overhead, employee compensation, and de minimis costs were applicable to some but not all assets obtained in connection with the acquisition of a trade or business. The final regulations, however, provide a single set of rules for amounts paid to facilitate such acquisitions, regardless of whether the transaction is structured as an acquisition of the entity or as an acquisition of assets (including tangible assets) constituting a trade or business. This change should greatly benefit taxpayers, who no longer face the prospect of having to apply one set of rules to intangibles and another set of rules to tangible property acquired as part of the same transaction.

If the taxpayer engages in one of the enumerated transactions, it must capitalize any costs that facilitate the transaction, again defined as those incurred in the process of investigating or pursuing that transaction. The final regulations identify a number of specific costs that are not seen by the IRS as facilitating the transaction (for example, the purchase price of the property, business integration costs, mandatory stock distributions, and borrowing costs). Other costs, including most success-based fees and the cost of valuing the target, are facilitative.

The final regulations create a special category of transactions--"covered transactions"--having its own set of guidelines. "Covered transactions" are defined as (i) the taxpayer's taxable acquisition of assets comprising a trade or business; (ii) the taxable acquisition of an ownership interest in another entity if the acquirer and target are related immediately thereafter; or (iii) a reorganization described in section 368(a)(1)(A), (B), or (C), or a reorganization described in section 368(a)(1)(D) in which stock or securities of the corporation to which the assets are transferred are distributed under either section 354 or 355.

Costs facilitate a covered transaction only if they are either "inherently facilitative" or are incurred after a "bright-line" date. Costs are inherently facilitative only if they are paid for (i) securing an appraisal, formal written evaluation, or fairness opinion relating to the transaction; (ii) structuring the transaction, including negotiating the structure of the transaction and obtaining tax advice on the structure of the transaction (for example, obtaining tax advice on the application of section 368); (iii) preparing and reviewing the documents that effectuate the transaction (for example, a merger agreement or purchase agreement); (iv) obtaining regulatory approval of the transaction, including preparing and reviewing regulatory filings; (v) obtaining shareholder approval of the transaction (for example, proxy costs, solicitation costs, and costs to promote the transaction to shareholders); or (vi) conveying property between the parties to the transaction (for example, transfer taxes and title registration fees). Consistent with the regulations' reliance on lists and examples rather than general rules or principles, this list appears to be exclusive, leaving little or no room for interpretation as to other costs that also may be inherently facilitative.

If a cost relating to a covered transaction is not inherently facilitative, it needs to be capitalized only if it is incurred after the later of the date on which a letter of intent, exclusivity agreement, or similar written communication (other than a confidentiality agreement) is executed by representatives of the acquirer and the target, or the date on which the material terms of the transaction are authorized by the taxpayer's board of directors (or other appropriate officials).

The "covered transactions" rule appears to have been an attempt to remedy the analytical problems created by Rev. Rul. 99-23. (33) Under the principles of that revenue ruling, a taxpayer must capitalize costs incurred in connection with the acquisition of a new trade or business after the date on which the taxpayer decides whether to acquire another business and which business to acquire. (34) Trying to identify this "whether-and-which" date proved elusive at best for taxpayers and IRS personnel. The "covered transactions" rule appears to be a compromise approach, identifying a bright-line date later than that favored by many revenue agents under the whether-and-which standard yet requiring the capitalization of "inherently facilitative" costs whenever they are incurred. Taxpayers should keep in mind, however, that this rule applies only to this one category of acquisitive transactions, and does not apply to other types of acquisitions, including the purchase of assets or ownership interests not comprising the entire trade or business. (35)

As with transaction costs incurred in acquiring or creating intangibles, taxpayers need not capitalize under Treas. Reg. [section] 1.263(a)-5 any overhead or employee compensation. In addition, Treas. Reg. [section] 1.263(a)-5 will not apply so long as the aggregate transaction costs incurred in connection with a transaction do not exceed $5000. This de minimis rule, however, does not apply to any commissions paid to facilitate a transaction described in Treas. Reg. [section] 1.263(a)-5. Treasury informally has indicated that this exclusion stems from well-settled law requiring taxpayers to capitalize brokerage and other fees incurred in purchasing stock (for example). Without intending to look a gift horse in the mouth, one could question why Treasury doubted its authority to permit a deduction for this one category of transaction costs based on existing authority while at the same time permitting a blanket deduction for all overhead and employee compensation--including bonuses and other amounts directly traceable to successful acquisitions--despite the Supreme Court's holding in Idaho Power. Given that the government felt free to set aside or at least to limit Supreme Court precedent in certain instances, the interests of simplification suggest that the same treatment should be accorded to commissions as well.

Cost Recovery

Although the final regulations require taxpayers to capitalize a wide range of transaction costs associated with nearly all acquisitions, reorganizations, and recapitalizations, even the government admits that it does not know how a taxpayer is to account for many of the costs once they are capitalized. Costs incurred by an acquirer in a taxable acquisition of either stock or assets must be capitalized to the basis of the acquired property. (36) The target's costs associated with the taxable acquisition of its assets reduce its amount realized on the sale of the assets. (37) The final regulations provide no guidance, however, regarding the tax treatment of costs capitalized in connection with any tax-free acquisition, or the target's costs in a taxable stock acquisition. In Notice 2004-18, 2004-11 I.R.B. 605, the government announced its intention to propose regulations addressing the proper tax treatment of such costs and invited public comment on the topic.

Observations

The final INDOPCO regulations are an important contribution to what Treasury promises to be the continuing evolution of our tax laws toward simpler rules that are more readily administered by and less burdensome upon taxpayers. Interestingly, the structure and operation of the final regulations suggest a determination on the part of the IRS National Office and Treasury to curtail the seemingly endless disputes between taxpayers and the field as well as between the National Office and the field as to the proper scope of INDOPCO's significant future benefit standard. (38) The regulations implement this resolve by essentially removing all discretion from everyone within the IRS and Treasury other than the senior-most leadership (those that have final approval of all regulations and revenue rulings) in identifying "significant future benefits" requiring capitalization. The structure of the regulations themselves--providing lists and examples rather than principles and general rules--also suggests a determination to prevent unintended or overly creative interpretations of the regulations by simply minimizing the number of rules available to be interpreted. In other words, Treasury and the National Office will simply tell us specifically which costs are to be capitalized, rather than requiring taxpayers or agents to apply standards to a set of facts. (39)

Perhaps most telling of this resolve (or exasperation, again depending on your perspective), is the government's reversal of the notion that "capitalization is the norm," with deductibility--at least in the context of created intangibles--now being the default rule. This is a radical departure from what had been a centerpiece of the government's decades-old view of the interaction of sections 162 and 263, and the ultimate ramifications of this fundamental shift remain to be seen.

The regulations' reliance on lists and examples rather than rules and principles is something of a double-edged sword. While it reflects the senior leadership's determination to curtail once and for all what many had perceived to be some agents' excessive zeal in the wake of INDOPCO, this approach might not have been the ideal long-term solution. While a set of lists and examples is well-tailored to respond to current issues and controversies, it leaves little room for adaptation as new issues emerge or current issues evolve. As much as we would all like to believe that this regulation will put an end to controversy in this area, our collective experiences in dealing with capitalization issues suggests this may be overly optimistic. Hopefully Treasury and the National Office will stand ready to respond quickly and decisively in amending the new regulations as this area inevitably evolves in unexpected ways.

Nor should the National Office and Treasury view the current effort as being complete. Taxpayers clearly need immediate guidance under Treas. Reg. [section] 1.263(a)-5 regarding the tax treatment of transaction costs capitalized in connection with tax-free acquisitive transactions, as well as costs capitalized by a target in connection with taxable stock acquisitions. Notice 2004-18 suggests that this guidance is under development, but given that the capitalization requirement is already in place, the need for amortization guidance is immediate. As Yale Law School Professor Michael Graetz has said, "Capitalization without amortization is tyranny." (40)

In addition, Treasury and the National Office should periodically review the $5000 limitation currently placed on the two new de minimis rules and increase that figure as needed. If they do not undertake such a review as a routine matter, taxpayers should not hesitate to remind them of the regulations' implicit commitment to do so.

Third, the IRS should "scrub" the Cumulative Bulletin to remove all revenue rulings and other published guidance inconsistent with the final regulations or that no longer reflect the views of the IRS. Although the final regulations have the practical effect of obsoleting inconsistent rulings even without the need for affirmative action by IRS, formally removing the old rulings will prevent unnecessary and frustrating discussions and debates over the continuing validity of a particular ruling. The IRS has indicated informally that such a project is in fact underway.

Taxpayers too should keep in mind that the final INDOPCO regulations are not the end of the analysis. The preamble and the text of the regulations remind taxpayers that Treas. Reg. [section] 1.263(a)-4 and Treas. Reg. [section] 1.263(a)-5 must be applied in conjunction with any other potentially applicable Code section. (41) A cost not capitalized under the INDOPCO regulations still may be subject to capitalization under section 263A. For example, the IRS has stated in public remarks that while package design costs are not capital expenditures under Treas. Reg. [section] 1.263(a)-4, (42) the costs still may be subject to capitalization under the uniform capitalization rules. Recently issued Rev. Proc. 2004-18 reminds taxpayers of the perils of assuming that the inapplicability of section 263(a) always equates to a current deduction. (43)

Finally, taxpayers should not hesitate to seek the formal or informal advice of the subject matter experts in the IRS National Office whenever there is a planning question or dispute on audit regarding the intended interpretation of the INDOPCO regulations. (44) The subject matter experts in the Income Tax & Accounting division of Chief Counsel often are more inclined to apply regulations with greater flexibility than might be the case on audit, and the new Technical Expedited Advice Memorandum procedures have successfully reduced the length of time required to obtain such assistance.

On balance, although neither the government nor taxpayers should view the new INDOPCO regulations as the end of the capitalization story, the changes should go a long way to resolving a wide range of expensive, time-consuming controversies and as such are a welcome addition to the tax accounting landscape.

(1) 503 U.S. 79 (1992).

(2) Commissioner v. Lincoln Savings & Loan Ass'n, 403 U.S. 345 (1971).

(3) Lincoln Savings, 403 U.S at 354.

(4) NCNB Corp. v. United States, 684 F.2d 285 (4th Cir. 1982) (en banc); Briarcliff Candy Corp. v. Commissioner, 475 F.2d 775 (2d Cir. 19737.

(5) National Starch & Chemical Corp. v. Commissioner, 918 F.2d 426 (3d Cir. 1990), citing Iowa-Des Moines National Bank v. Commissioner, 592 F.2d 433 (8th Cir. 1979) and Colorado Springs National Bank v. United States, 505 F.2d 1185 (10th Cir. 1974).

(6) INDOPCO, 503 U.S. at 87.

(7) See, e.g., Rev. Rul. 94-12, 1994-1 C.B. 36; Rev. Rul. 94-77, 1994-2 C.B. 19.

(8) See PNC Bancorp, Inc. v. Commissioner, 212 F.3d 822 (3a Cir. 2000), and materials cited therein; Timothy J. McCormally, "A Lump of Coal or a Nicely Wrapped Present?" 97 TNT 27-74 (Feb. 10, 1997) (remarking on TEI's concern about the "flurry of audit activity" and challenges to traditionally deductible costs following INDOPCO).

(9) See, e.g., Remarks of Former IRS Chief Counsel Stuart Brown, quoted in "No Easy Answers to INDOPCO Issues," 2000 TNT 28-2 (Feb. 10, 2000).

(10) See, e.g., PNC Bancorp, 212 F.3d 822 (3d Cir. 2000); U.S. Freight-ways v. Commissioner, 270 F.3d 1137 (7th Cir. 2001); Wells Fargo & Co. v. Commissioner, 224 F.3d 874 (8th Cir. 2000). But see Lychuk v. Commissioner, 116 T.C. 374 (2001).

(11) T.D. 9107, 69 Fed. Reg. 436 (Jan. 5, 2004). The regulations finalize a notice of proposed rulemaking published on December 19, 2002 (67 Fed. Reg. 77701) (the NPRM). The principles underlying the final regulations were first announced in an advanced notice of proposed rulemaking published on January 24, 2002 (67 Fed. Reg. 3461).

(12) Notice 2004-6, 2004-3 I.R.B. 308.

(13) Treas. Reg. [section] 1.263A-10 (using a "functional interdependence" test to define a unit of property for purposes of the interest capitalization rules).

(14) Treas. Reg. [section] 1.263(a)-4(b)(2).

(14A) Taxpayers also must capitalize costs incurred to create or enhance a "separate and distinct intangible asset." Treasury officials have stated that this rule is intended primarily as a "backstop," because the eight specific categories of created intangibles are believed to include all "separate and distinct intangible assets" as well.

(15) Interstate Transit Lines v. Commissioner, 319 U.S. 590 (1943); New Colonial Ice Co. v. Helvering, 292 U.S. 435 (1934). But see Peter Lowry, "Deductions Should Not Be Narrowly Construed," 89 Tax Notes 1181 (Nov. 27, 2000).

(16) See, e.g., FSA 1999492 (undated), available at 1999 TNT 11-75, citing INDOPCO, 503 U.S. at 84.

(17) Rev. Rul. 2000-4, 2000-1 C.B. 331.

(18) Van Iderstine Co. v. Commissioner, 261 F.2d 211 (2d Cir. 1958).

(19) See, e.g., Louisville Fire Brick Works, Inc. v. Commissioner, 43 B.T.A. 178 (1940) (cost of railroad spur owned by railroad capital expenditure); Rev. Rul. 69-229, 1969-1 C.B. 86 (cost of constructing state-owned highway bridge over railroad tracks capitalized); Rev. Rul. 68-607, 1968-2 C.B. 115 (cost of improvements to state-owned right of way to provide access to shopping center capitalized).

(20) Kauai Terminal, Ltd. v. Commissioner, 36 B.T.A. 893 (1937).

(21) T.D. 8482, 58 Fed. Reg. 42198 (Aug. 9, 1993).

(22) 1971-2 C.B. 549, modified and super. Rev. Proc. 71-21 permits taxpayers to defer the recognition of income on prepayments under a service contract where the services must be performed before the end of the taxable year following payment. As a relief measure under section 451 and the Supreme Court's decision in Schlude v. Commissioner, 371 U.S. 884 (1963), the revenue procedure provided only analogous support for the rule in the final regulations.

(23) See note 10 supra. See also Zaninovich v. Commissioner, 616 F.2d 429 (9th Cir. 1980).

(24) See I.R.C. [section] 197(c) and Treas. Reg. [section] 1.197-2(d).

(25) See, e.g., Treas. Reg. [section] 1.263(a)-4(f)(6).

(26) Commissioner v. Idaho Power Co., 418 U.S. 1 (1974).

(27) PNC Bancorp, Inc. v. Commissioner, 212 F.3d 822 (3d Cir. 2000).

(28) Wells Fargo & Co. v. Commissioner, 224 F.3d 874 (8th Cir. 2000).

(29) 2004-16 I.R.B. 785.

(30) 2002-1 C.B. 327.

(31) RJR Nabisco, Inc. v. Commissioner, T.C. Memo 1998-252.

(32) Treas. Reg. [section] 1.263(a)-5(a).

(33) 1999-1 C.B. 998.

(34) Although by its terms Rev. Rul. 99-23 addresses only the applicability of section 195 to costs incurred in connection with a new trade or business unrelated to the taxpayer's existing business, many read the ruling as establishing a general capitalization principle distinguishing between deductible investigatory costs and capitalizable acquisition costs. Likewise, Treas. Reg. [section] 1.263(a)-5(e) does not distinguish between costs of acquiring a trade or business that is the same as or different from the taxpayer's existing trade or business.

(35) For example, the purchase of stock or a partnership interest not resulting in the purchase of the entire business or of an ownership interest resulting in the parties being related immediately afterward would be governed by Treas. Reg. [section] 1.263(a)-4.

(36) Treas. Reg. [section] 1.263(a)-5(g)(2)(i).

(37) Treas. Reg. [section] 1.263(a)-5(g)(2)(ii)(A).

(38) See, e.g., remarks of former Treasury Tax Specialist Christine Turgeon, quoted in "The INDOPCO Grocery List," 93 Tax Notes 320 (Oct. 15, 2001) (expressing frustration with the manner in which revenue agents applied capitalization revenue rulings).

(39) One prominent commentator seems to have predicted and even advocated this approach. See Lee Sheppard, "The INDOPCO Grocery List," 93 Tax Notes 320 (Oct. 15, 2001) ([T]here's nothing wrong with lists.... Give the agents a grocery list, if that would help resolve cases."); Lee Sheppard, "What Part of Capitalize Don't You Understand?" 88 Tax Notes 1435 (Sept. 18, 2000) ("If it would make both sides happy for the IRS examiners to have a cookbook that says, 'require capitalization of this and not that,' then write a cookbook.").

(40) Sheryl Stratton, "No Easy Answers to INDOPCO Issues," 2000 TNT 28-2 (Feb. 10, 2000).

(41) See, e.g., Treas. Reg. [section] 1.263(a)-4(b)(4) and 1.263(a)-4(f)(6).

(42) Treas. Reg. [section] 1.263(a)-4(b)(3)(v).

(43) Rev. Rul. 2004-18, 2004-8 I.R.B. 509, holds that manufacturers must capitalize environmental cleanup costs as production costs by reason of section 263A. Although Rev. Rul. 94-38, 1994-1 C.B. 35, had held such costs to be ordinary and necessary business expenditures, the IRS has now taken the position that the earlier ruling was intended to address only section 263(a) and was not intended to suggest that manufacturers need not consider the possible applicability of section 263A.

(44) For an expanded discussion of the benefits of approaching the National Office, see James Atkinson, "FedEx v. Commissioner: The Continuing Debate Over Cyclical Maintenance Costs," 55 Tax Executive 462 (Nov-Dec 2003).

JAMES L. ATKINSON is Counsel with Miller & Chevalier Chartered in Washington, D.C. Prior to joining the firm, Mr. Atkinson was the IRS Associate Chief Counsel (Income Tax & Accounting).