The impact of INDOPCO on subsequent rulings.

In its 1992 INDOPCO decision, the Supreme Court ruled that investment banking and legal fees paid by a target corporation in a friendly takeover were to be treated as nondeductible capital expenditures and not as currently deductible business expenses. Perhaps more significant than the narrow ruling relating to friendly takeovers was the direction the Court took in deciding INDOPCO. Rather than developing a general test to solve the "capital versus deductible expense" problem, it adopted a facts-and-circumstances approach. The Court determined that the investment banking and legal fees would provide the target corporation with significant benefits beyond the current tax year and thus were capital in nature. It rejected the argument that a separate and distinct asset must be created by the expenditures in order to require capitalization. The Court further emphasized that a tax deduction is a matter of legislative grace and is an exception to the norm of capitalization.

Many commentators have questioned whether INDOPCO would lead to the required capitalization of common expenditures that arguably have at least some general future benefit. These categories would include advertising, business expansion, employee training, recapitalization, reorganization and other similar expenditures. It has been over a year now since INDOPCO was decided; in that time the INDOPCO decision has influenced many rulings and court decisions.

Letter Ruling 9237006

In Letter Ruling (TAM) 9237006, the IRS reached a conclusion that allowed the current deductibility of expenses. A public utility was building a nuclear facility. The utility was required to hire accountants to conduct an audit to determine if the costs were reasonable before requesting rate increases that reflected the cost of construction. On examination, the Service disallowed the deduction of the cost of the audit on the grounds that the audit allowed for future rate increases that would extend beyond the current tax year.

The IRS National Office, however, did not see the audit as being responsible for the rate increases. It contended that the cost of the nuclear facility itself was the basis for rate increases (rather than the audit) and the cost of the nuclear facility had been capitalized.

Letter Ruling 9240004

In Letter Ruling (TAM) 9240004, a taxpayer's plant contained processing and manufacturing equipment insulated with asbestos. There were two alternatives that would have allowed the taxpayer to comply with state and Federal regulations: (1) a program of continuous monitoring and encapsulation or (2) removal of the asbestos and replacement with asbestos-free insulation. The taxpayer selected the second alternative because of the long-term cost effectiveness.

The taxpayer advanced three arguments for currently deducting the cost of removal and replacement: 1. The cost was incidental and minor when compared to total repair costs and value of the equipment. 2. The equipment was not increased in value by the removal of asbestos and replacement of asbestos-free insulation, since both materials performed the same function. 3. The cost was not comparable to typical capital expenditures because the expenditures were not for new units or components.

The IRS rejected the taxpayer's arguments. It concluded that the value of the equipment had in fact increased in two ways because of the removal of the asbestos. First, the taxpayer's risk of liability to contaminated employees was decreased; second, the equipment was more marketable once the asbestos had been removed. Also, in the Service's view, the removal expenditure had affected operating efficiencies by reducing the possibility of equipment interruptions due to safety violations.

INDOPCO was cited as establishing a general rule of capitalization. It is clear that, in the IRS's view, deductions are to be strictly construed and allowed only when there is clear authority for them in the Code. In citing INDOPCO, the Service concluded that the taxpayer's asbestos removal costs created long-term, substantial future benefits that accrued beyond the year in which the costs were incurred. The taxpayer was required to capitalize the cost of asbestos removal and replacement with asbestos-free material.

Rev. Rul. 92-80

The IRS may well have been reacting to the fears mentioned earlier of a "long-term analysis" assault on many expense categories when it issued Rev. Rul. 92-80. The ruling announced that the treatment of advertising costs as a deductible business expense was not affected by INDOPCO. Only in unusual circumstances when advertising was directed toward obtaining future benefits beyond those traditionally associated with institutional or goodwill advertising did the cost of that advertising have to be capitalized. The IRS cited Cleveland Electric Illuminating Co., 7 Ct. Cl. 220 (1975), as an example of advertising requiring capitalization. In that case, advertising costs were incurred to counter public opposition to the granting of a license to construct a power plant.

There are many other common business expenditures that offer at least some general long-term benefit similar in nature to advertising expenditures now covered by Rev. Rul. 92-80. Only time will tell if the Service will cover other common expenditures with a similar ruling.

Letter Ruling 9315004

The costs of a company's environmental cleanup of PCB contamination were treated as capital expenditures rather than currently deductible business expenses in Letter Ruling (TAM) 9315004, since the cleanup operation involved substantial modifications that were replacements and betterments to company property. The INDOPCO decision is only mentioned once late in the ruling, for the proposition that capitalization is the norm and deduction is the exception.

Victory Markets, Inc.

One question concerning INDOPCO that remains unclear is whether it applies to unfriendly as well as friendly takeovers. The Court made it clear that it was aware that a friendly takeover was involved. However, the Service has announced that it will apply the INDOPCO decision to both friendly and unfriendly takeovers.

Victory Markets, Inc., 99 TC No. 34 (1992), at first glance, appeared to involve an unfriendly takeover that would allow clarification on the applicability of INDOPCO. The taxpayer incurred expenditures for investment and legal fees after receiving an offer to be acquired by another corporation. The directors of the company rejected the tender offer as inadequate and adopted a "poison pill" plan in order to deter a hostile takeover. The directors then accepted a subsequent higher offer without ever activating the "poison pill" plan.

The Tax Court ruled that this was actually a friendly takeover and INDOPCO should apply. The fact that the directors never activated the "poison pill" plan and that the acquirer corporation never tried to circumvent the directors by making a tender offer directly to the shareholders were the principal factors that convinced the Tax Court. As a friendly takeover, there was no question as to the applicability of INDOPCO and the capitalization of the expenses.

Conclusion

It is obvious that INDOPCO has had an effect on rulings since its resolution. However, some questions still remain. The extent to which the IRS may try to apply INDOPCO is still not clear. The IRS has exempted most advertising expenditures but remain silent on many other common The application of INDOPCO to all takeovers by the IRS is clear; however, judicial opinion on the applicability of INDOPCO to unfriendly takeovers remains to be determined.