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Comments on ANPR on capitalization: April 24, 2002.

On April 24, 2002, Tax Executives Institute filed comments with the U.S. Treasury Department and Internal Revenue Service in response to a request in an Advance Notice of Proposed Rulemaking, Announcement 2002-9, relating to guidance addressing the capitalization of expenditures that create or enhance intangible assets or benefits. The forthcoming proposed rules are intended to provide greater certainty in respect of the treatment of such expenditures and to reduce the scope and number of capitalization controversies that have arisen since the decision in INDOPCO v. United States. The comments were prepared by TEI's Federal Tax Committee, whose chair is Mitchell S. Trager of Georgia-Pacific Corporation.

On January 17, 2002, the Treasury Department and Internal Revenue Service released an Advance Notice of Proposed Rulemaking (ANPR) that describes rules and standards the Treasury Department and IRS expect to propose in 2002 in order to provide a framework for the treatment of expenditures incurred in acquiring, creating, or enhancing intangible assets. Announcement 2002-9 was subsequently published in the Federal Register (67 Fed. Reg. 3461) and in the Internal Revenue Bulletin (2002-7 I.R.B. 536). The Announcement invites public ,comment on the rules and standards set forth in the ANPR and also requests comments and recommendations for alternative rules. On behalf of Tax Executives Institute, I am pleased to submit the following comments.

Background

Tax Executives Institute is the preeminent association of business tax executives in North America with more than 5,300 members representing 2,800 of the leading corporations in the United States, Canada, and Europe. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and the government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works--one that is administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the rules and standards that govern the application of section 263(a) to expenditures that result in taxpayers acquiring, creating, or enhancing intangible assets or benefits.

Taxpayers, the IRS, and courts, have long struggled with the distinctions between costs that are deductible when incurred and those that should be capitalized. Since the Supreme Court's decision in INDOPCO v. Commissioner, 503 U.S. 79 (1992), whether a particular expense may be deducted currently or must be capitalized has become a particularly troublesome issue. (1) While the IRS National Office has consistently said that INDOPCO did not alter the fundamental principles of capitalization, (2) the decision has been cited by revenue agents to justify adjustments capitalizing numerous expenditures, many of which have long been viewed as clearly deductible. As a result, the number, scope, and frequency of disputes between taxpayers and the IRS over such issues have escalated substantially. Indeed, the National Taxpayer Advocate identified capitalization issues as the most litigated issue for business taxpayers in the 1998 Report to Congress, and there is no sign the controversy has abated. In addition, the IRS's Large and Mid-Size Business Division has reported that more than 25 percent of its audit resources are devoted to capitalization issues in some industries. (3)

TEI has frequently urged the IRS to set forth a clear, consistent, administrable, and practical framework for addressing capitalization issues, including safe harbors and rules of administrative convenience that may be applied in evolving business environments without intensive analysis of each taxpayer's particular circumstances. Hence, TEI commends the government for issuing the ANPR and inviting public comments on the treatment of various costs related to the acquisition, creation, or enhancement of intangible assets or benefits. We believe that the consultative process will enable the government to issue rules that will reduce compliance and administration costs and minimize uncertainty and controversy for the benefit of both taxpayers and the government. Indeed, to minimize resources devoted to unproductive controversies, we recommend that the final rules not only be effective immediately; but also that guidance be issued stating that the government will not challenge a taxpayer's treatment of expenditures in prior years to the extent such treatment is consistent with the new rules. (4)

General Deductibility

The ANPR describes categories of expenditures for the acquisition, creation, or enhancement of intangible assets or benefits for which capitalization will be required. The government anticipates "that other expenditures to acquire, create, or enhance intangible, assets or benefits generally will not be subject to capitalization under section 263(a)." (5) TEI urges the government to formally adopt a rule of "general deductibility" and to make that rule explicit. To minimize uncertainty and curtail controversy, the proposed rules of administrative convenience for deductibility of expenditures outlined in the ANPR must constitute the principal and controlling guidance. During the past 10 years, a number of revenue rulings have been issued that were intended to quell controversies by according taxpayers deductions for specific expenditures. Regrettably, revenue agents have narrowly construed the rulings by characterizing many routine expenditures as "rare and unusual" and thus outside the scope of the ruling's general rule of deductibility. TEI encourages the government to include in the proposed regulations the explicit statement that expenditures, other than the cost categories specifically identified as subject to capitalization, will generally be deductible.

Twelve-Month Rule

The ANPR states that the government expects to propose a rule in which
 capitalization under section 263(a) would not be required for an
 expenditure unless that expenditure created or enhanced intangible rights
 or benefits for the taxpayer that extend beyond the earlier of (i) 12
 months after the first date on which the taxpayer realizes the rights or
 benefits attributable to the expenditure, or (ii) the end of the taxable
 year following the taxable year in which the expenditure is incurred. (6)


TEI supports broad application of the proposed 12-month rule. Where the future benefit or life of an asset is 12 months or less, it is unlikely that taxable income will be materially distorted by permitting a current deduction even where an expenditure produces an incidental benefit or has a life extending beyond the end of the tax year. In addition, many expenditures with a useful life of 12 months or less are apt to be regular and recurring in nature so a deduction for such items would likely produce a better matching of income and expenses. As a result, TEI believes that a broadly applied 12-month rule will significantly reduce controversy, will provide simplification for taxpayers, and is consistent with the government's objective of "translating general capitalization principles into clear, consistent, and administrable standards." (7)

The ANPR solicits comments "on how the proposed 12-month rule might apply to expenditures paid to create or enhance rights of indefinite duration and contracts subject to termination provisions. For example, comments are requested on whether costs to create contract rights that are terminable at will without substantial penalties would not be subject to capitalization as a result of the 12-month rule." (8)

For purposes of applying the 12-month rule, TEI recommends that the expected economic life of an intangible asset be the basis for measuring the period of the benefits. This is consistent with the principles of current law, including, among other rules, Treas. Reg. [section] 1.167(a), et seq. For example, where a taxpayer paid a fee to obtain a contract or lease for a term of 24 months, the fee would be amortized over 24 months.

In determining the expected economic life of an intangible asset, the ANPR does not indicate what rules might be prescribed regarding the application of the 12-month rule where renewal periods are included at the inception of the contract, lease, or the grant of government rights. TEI believes that only the initial period stated in the contract, lease, or government grant should be considered, unless at the time of the grant or the creation of the contract or lease there is a substantial likelihood that the grant, contract, or lease will be renewed. For this purpose, certain renewal rights should be ignored. Specifically, where a grant, contract, or lease provides for renewals at prevailing fair market prices or rates at the end of the term of the contract, renewal periods should be ignored because only the initial term is guaranteed. Indeed, where a right of renewal is subject to renegotiation of any material term at the conclusion of the initial term, the right is little more than an agreement to agree and the renewal period should be ignored. For example, an amount paid by a service provider to a sales agent (e.g., a commission) for a 12-month contract that is renewable by the customer at the prevailing price at the end of the term should not be subject to capitalization simply because the customer can subsequently renew that agreement at then-prevailing rates on a month-to-month or year-to-year basis.

The ANPR also requests comments on the treatment of intangible assets or benefits of indefinite duration. Outside of transaction costs related to the acquisition of business entities or for government licenses, there are few expenditures that create intangible benefits of indefinite duration. In rare cases where such expenditures are found, they likely constitute regular and recurring costs that are properly deductible because they are routine costs of producing the taxpayer's regular business income. In the event that the government determines that there are expenditures (outside of transaction costs for business acquisitions and government licenses) that create rights of indefinite duration and such costs should be capitalized, we urge the government to provide a general amortization period of, say, 60 months. For additional comments on the need for a general amortization period, please refer to the sections on "Transaction Costs" and "Other Items on Which Public Comment Is Requested."

Finally, expenditures to create contract rights that are terminable at will without payment of substantial penalties by the customer should be immediately deductible because at the time the expenditure is incurred the future benefits, if any, are highly speculative. Since there is no ascertainable benefit to the taxpayer that extends beyond the date the contract is signed, any expenditure related to the creation of such an agreement should be immediately deductible.

Prepaid Items

TEI supports the application of the 12-month rule to permit an immediate deduction for amounts prepaid for goods, services, or other benefits (such as insurance) to be received in the future, but submits that guidance to illustrate the interaction of the 12-month rule with the economic performance rules of section 461(h) may be necessary. Specifically, the three-and-a-half month rule in Treas. Reg. [section] 1.461-4(d)(6)(ii) should be modified to take the 12-month rule into account in order to afford the taxpayer a deduction.

Amounts Paid to Obtain Certain Rights From a Governmental Agency

Subject to the 12-month rule, the ANPR states that the proposed rules are expected to require "capitalization of an amount paid to a governmental agency for a tradename, trademark, copyright, license, permit, or other right granted by the governmental agency." (9) As an example, the ANPR cites payments made by a restaurant to a state in order to obtain a license of indefinite duration to serve alcoholic beverages. In some states, liquor licenses require the payment of an initial fee as well as subsequent annual renewal fees. If the regulations employ liquor licenses as an example to illustrate that amounts paid to obtain rights from the government are subject to capitalization, the regulations should specify that only the initial fee is subject to capitalization; annual renewal fees should be deductible under the 12-month or "regular and recurring" rule. In addition, even the initial fees should be subject to a general amortization rule.

Amounts Paid to Obtain or Modify Contract Rights

A. General Rule. Subject to the 12-month rule, the proposed rules are expected to require "capitalization of amounts in excess of a specified dollar amount (e.g., $5,000) paid to another person to induce that person to enter into, renew, or renegotiate an agreement that produces contract rights enforceable by the taxpayer, including payments for leases, covenants not to compete, licenses to use intangible property, customer contracts and supplier contracts." (10) The ANPR invites comments on whether there are standards other than the proposed standard that would be more appropriate. The ANPR also clarifies that the standard would apply to payments from a lessee to a lessor to enter into or modify a lease, but it would not require capitalization of amounts paid to terminate a lease. In addition, the proposed rules will not require capitalization where the payment "merely creates an expectation that a customer or supplier will maintain its business relationship with the taxpayer." (11)

TEI believes the proposed standard is based on a workable distinction between payments to create enforceable contracts, which are subject to capitalization, and payments that create a mere expectation of a future business relationship, which are deductible. Additional examples to illustrate the operation of the proposed rule, however, may be necessary. For example, a payment to create a contract right that entitles a taxpayer to sell a specific quantity of goods at a fixed price is an enforceable contract for which payment should be capitalized. (12) In contrast, a taxpayer's payment for "best efforts" sales or for rights conditioned on future acts by another party (e.g., slotting allowance or similar stocking payments) should not be subject to capitalization.

The proposed regulations should provide that an enforceable contract right is created whenever a taxpayer acquires a right to use tangible or intangible property or is to be compensated under a contract for the use of property. Thus, a payment to acquire a lease or license is subject to capitalization. In addition, where a taxpayer acquires a right to buy (or sell) a fixed or minimum amount of goods or services at a fixed price for a fixed period (in excess of 12 months), a payment to acquire the right to buy (or sell) may be subject to capitalization because there is a future benefit that extends over the period of the supply or sales agreement. (13) Absent any one of the conditions, however, any payment for such an agreement creates an expectation of a future agreement rather than an intangible benefit.

B. De Minimis Expenditures. TEI supports the government's proposal to adopt a de minimis rule permitting deductions for all expenditures of $5,000 or less per vendor (or provider) per transaction for intangible assets or benefits. We question, however, whether a $5,000 threshold affords meaningful simplification for larger taxpayers and urge the government to consider adopting a higher dollar amount. Indeed, we encourage the government to consider adopting a flexible threshold by permitting taxpayers to employ the minimum capitalization threshold adopted for financial statement reporting. (14)

In order for a de minimis expenditure threshold to be effective, the regulations should be clear that the rule applies to all cost categories and expenditures. Moreover, taxpayers should not be required to aggregate deductible costs (e.g., employee compensation or fixed overhead expenses) and nondeductible costs for purposes of determining whether the de minimis threshold is exceeded. Excluding certain costs from the de minimis rule or requiring aggregation of different costs or invoices from different vendors in order to determine whether the threshold is exceeded will undermine the rule, increase overall complexity, and increase compliance burdens for taxpayers and the resources the government must devote to examinations. Finally, any fixed de minimis expenditure threshold--whether $5,000 or higher--should be adjusted periodically for inflation.

Amounts Paid to Terminate Certain Contracts

Subject to the 12-month rule, the proposed rules would require--
 capitalization of an amount paid by a lessor to a lessee to induce the
 lessee to terminate a lease of real or tangible personal property or by a
 taxpayer to terminate a contract that grants another person the exclusive
 right to conduct business in a defined geographic area. For example, under
 the rule, a lessor that pays a lessee to terminate a lease of real property
 with a remaining term of 24 months would be required to capitalize such
 payment. [Citations omitted.] On the other hand, if the lease had a
 remaining term of 6 months, the 12-month rule would apply, and the taxpayer
 would not be required to capitalize the termination payment under the rule.
 (15)


It is unclear how the 12-month rule would be applied in the example given in the ANPR. Where a lease termination payment is made and no new lease is entered into within 12 months, an abandonment loss should arguably be permitted under section 165, notwithstanding the decision in Peerless Weighing and Vending Machine Corp v. Commissioner. (16) Moreover, where the lessor enters a lease with a new lessee the amortization period should be the shorter of the remaining life of the terminated lease or the new lease term.

Amounts Paid in Connection with Tangible Property Owned by Another

Subject to the 12-month rule, the ANPR states that the proposed rules will require
 capitalization of amounts in excess of a specified dollar amount paid to
 facilitate the acquisition, production, or installation of tangible
 property that is owned by a person other than the taxpayer where the
 acquisition, production, or installation of the tangible property results
 in the type of intangible future benefit to the taxpayer for which
 capitalization is appropriate. This rule would apply even though there is
 no contractual relationship between the taxpayer and the other person. This
 rule is intended to require capitalization of expenditures that produce
 intangible future benefits similar to those that were in issue in Kauai
 Terminal Ltd. v. Commissioner, 36 B.T.A. 893 (1937) (expenditure incurred
 to construct a publicly owned breakwater for the purpose of increasing
 taxpayer's freight lighterage operation). (17)


The ANPR invites comments on the standards to apply to ensure capitalization of such costs and on whether safe harbors or dollar thresholds should be used to determine capitalization.

If a special rule, or category of costs, is necessary to address the specific facts and circumstances in Kauai Terminal, TEI believes that such a rule should nonetheless be subject to the same safe harbors, de minimis expenditure threshold, and similar rules of administrative convenience that apply to all other categories of capitalized costs. In other words, safe harbors, de minimis expenditure thresholds, and other rules of administrative convenience should neither be limited to, nor unavailable for, amounts paid in connection with tangible property owned by others.

As the court noted in Kauai Terminal, the benefit realized by the taxpayer from the expenditure "was as desirable as if the breakwater had become its own." Hence, for any cost capitalized under the proposed rule, an amortization period should be provided that is no longer than the applicable depreciation provision that would apply if the taxpayer owned the property. Moreover, an abandonment loss should be permitted if the benefits cease before the taxpayer has recovered its unamortized cost. (18) If the government were, to require the benefit to be capitalized and amortized over an estimated period of "future benefit," there will likely be significant controversy over the anticipated life to be assigned to the intangible right. Such controversies can be minimized by employing the life of the tangible property for the amortization period.

Defense or Perfection of Title to Intangible Property

Subject to the 12-month rule, the ANPR states that the proposed rules will require "capitalization of amounts paid to defend or perfect title to intangible property. For example, under the rule, if a taxpayer and another person both claim title to a particular trademark, the taxpayer must capitalize any amount paid to the other person for relinquishment of such claim." (19)

TEI urges caution in restating the general rules in this area. There is a substantial body of law relating to the origin of the claim that delineates between (i) capital expenditures related to the defense or perfection of title and (ii) deductible costs related to defending the right to collect income attributable to the property. Thus, legal costs (or other payments) to defend or perfect title to land, patents, or copyrights are capitalized, but legal costs (or other payments) to prosecute or defend against patent (or copyright) infringement are generally deductible. The distinction should be preserved in the proposed rules.

Transaction Costs

The ANPR states that the "IRS and Treasury Department expect to propose a rule that requires a taxpayer to capitalize certain transaction costs that facilitate the taxpayer's acquisition, creation, or enhancement of intangible assets or benefits ... (regardless of whether a payment described in sections A or B [of Announcement 20029] is made)." (20) In addition,
 this rule would require a taxpayer to capitalize transaction costs that
 facilitate the taxpayer's acquisition, creation, restructuring, or
 reorganization of a business entity, an applicable asset acquisition within
 the meaning of section 1060(c), or a transaction involving the acquisition
 of capital, including a stock insurance, borrowing, or recapitalization.
 However, this rule would not require capitalization of employee
 compensation (except for bonuses and commissions that are paid with respect
 to the transaction), fixed overhead (e.g., rent, utilities and
 depreciation), or costs that do not exceed a specified dollar amount, such
 as $5,000. (21)


The IRS and Treasury Department are also considering alternative approaches to minimize uncertainty and to ease the administrative burden of accounting for transaction costs. For example, the rules "could allow a deduction for all employee compensation (including bonuses and commissions that are paid with respect to a transaction), be based on whether a transaction is regular or recurring, or follows the financial or regulatory accounting treatment of the transaction." (22)

A. Compensation Expense. Compensation expense (whether paid in the form of salaries, wages, bonuses, commissions, fringe benefits, or employee stock options) arises from the employer-employee relationship and should be deductible when incurred. The allocation of compensation paid in connection with, or to facilitate, the acquisition, creation, or enhancement of specific intangible assets or benefits is, at best, administratively burdensome and, at worst, after-the-fact guesswork, especially for those whose duties encompass a range of activities that only occasionally or incidentally relate to the acquisition or creation of intangibles. Requiring taxpayers to segregate, account for, and capitalize compensation costs on a transaction-by-transaction basis imposes a significant and unwarranted administrative burden. (23) Hence, TEI urges the government to adopt a rule stating that compensation is generally deductible regardless of its form and regardless of whether such amounts are paid to employees or contractors. (24)

B. Regular and Recurring Costs. The IRS and Treasury Department request comments on whether the recurring or nonrecurring nature of a transaction is an appropriate consideration in determining whether an expenditure to facilitate a transaction must be capitalized and if so what criteria Should be applied to distinguish recurring and nonrecurring costs.

TEI agrees that the regular and recurring costs incurred in connection with the production of the taxpayers' trade or business income should be deductible when incurred. (25) For example, all selling expenses, including the costs of soliciting and negotiating contracts with customers and compensation payable to employees and independent contractors, should be fully deductible. In addition, companies are constantly investing in market research activities, advertising, and other activities in order to expand their existing businesses. Such costs should also be fully deductible. Indeed, all routine, recurring costs that are part of the production of the taxpayer's business income should be deductible. Finally, we agree that the fixed overhead costs referred to in the ANPR (e.g., rent, depreciation, and utilities) should be deductible as regular and recurring expenditures.

C. Amortization of Capitalized Costs. Establishing an amortization period for all capitalized transaction costs is consistent with the government's goals of reducing controversy, minimizing uncertainty, and increasing the administrabilty of the tax law. Hence, TEI urges the Treasury Department and IRS to adopt a standard recovery period for all capitalized transaction costs. (26)

1. Amortization Period. We believe that substantial administrative simplification can be achieved by affording taxpayers an amortization deduction for capitalized transactions costs incurred in the acquisition, creation, or enhancement of intangible assets. To the extent such costs are not otherwise deductible under a 12-month, de minimis, regular or recurring, or other rule of administrative convenience, the costs should be amortized over 60 months.

Transaction costs incurred in connection with the acquisition, creation, or enhancement of intangibles, especially the acquisition of business entities or assets, are analogous to organizational start-up costs. Hence, we believe that the policy judgments evinced by Congress in establishing five-year recovery periods in section 195 (start-up expenditures), section 248 (corporation organizational expenses), and section 709 (partnership organization expenditures) provide the proper benchmark for determining the life to assign to transaction costs. By providing such a safe harbor amortization period, the government will facilitate the settlement of factual disputes between the IRS and taxpayers. (27)

2. Investigatory v. Facilitative Costs. In addition to establishing a standard amortization period for transaction costs, the government should also consider establishing a bright-line rule for determining when deductible investigatory costs become facilitative transaction costs subject to capitalization. By providing a bright-line rule for determining when capitalization is required, the government would reduce controversies. For example, in Wells Fargo & Co. v. Commissioner, 224 F.3d 874 (8th Cir. 2000), the court focused on July 22, 1991, the date the target and the acquirer entered into their Agreement and Plan of Reorganization as the date when the target made its "final decision" to be acquired. (28) TEI recommends that the government clarify the "whether and which" rules of Rev. Rul. 99-23 (29) and provide that costs incurred through the date of signing a binding acquisition agreement are deductible investigatory costs, whereas costs incurred after such date and through the closing of the agreement are capital. Such a rule would minimize the time and resources taxpayers and the government devote to analyzing the proper treatment of acquisition costs. (30)

Other Issues on Which Public Comment Is Requested

The ANPR invites comments on "general principles of capitalization [to] be used to identify costs of acquiring ... intangible assets or benefits that should be capitalized but are not described [in Announcement 2002-9.]" (31) The ANPR also solicits comments on (i) whether there should be a requirement for book and tax accounting conformity; (ii) safe harbor recovery periods for intangible assets that have no readily ascertainable useful lives, including whether the guidance should provide one uniform period or multiple recovery periods; and (iii) whether there are other types of expenditures for which it would be useful to prescribe de minimis rules that would not require capitalization.

A. General Principles of Capitalization. The ANPR includes a comprehensive catalog of intangible costs subject to capitalization. Hence, TEI is unpersuaded that the proposed regulations should adopt a general standard for capitalization. Indeed, adopting a general standard of capitalization will impede the goal of reducing controversy and invite challenges to the taxpayer's treatment of expenditures thereby resulting in the same level of uncertainty, inconsistency, and frustration as exists today. If after publishing the forthcoming regulations other categories of costs are identified that should be capitalized, the IRS can modify the regulations or issue other public guidance prescribing the treatment of the expenditures.

If contrary to TEI's recommendation the government proposes a general capitalization standard for unidentified costs, TEI recommends, as it urged in its amicus curiae brief in INDOPCO, adoption of a "separate and distinct asset" standard because it is more administrable and subject to less uncertainty than the nebulous "significant future benefit" standard. (32)

B. Book-Tax Accounting Conformity. Financial, regulatory, and tax reporting have different objectives when measuring the recognition of income and expense and, as a result, frequently adopt differing standards. (33) As a result, TEI recommends against prescribing a standard rule of capitalization whereby a taxpayer's income for tax purposes is determined by reference to financial or regulatory accounting methods. (34) There may be limited circumstances, however, where, as a matter of administrative convenience, the taxpayer's financial or regulatory accounting method can serve as a reasonable proxy for an income tax accounting method (e.g., a de minimis expenditure rule for tangible or intangible assets otherwise subject to capitalization).

C. Safe Harbor Cost Recovery Periods. The most contentious capitalization issues are those where revenue agents propose adjustments for intangible "significant future benefits" that have no readily ascertainable life and for which the current rules permit no amortization deduction. In order to minimize controversy, TEI recommends that the proposed regulations adopt a single, uniform recovery period of 60 months for expenditures for intangibles that have no readily ascertainable life and are not subject to section 197.

D. De Minimis Threshold for Tangible Property. TEI encourages the government to consider expanding the de minimis expenditure threshold concept to apply to tangible as well as intangible assets. For financial accounting purposes, taxpayers expense nominal value assets (i.e., those that fall below a certain dollar threshold) because the business decisionmakers have determined that the value of the assets is insignificant compared with the administrative cost of tracking them. For publicly traded companies, there is a natural tension between increasing the nominal value asset threshold (in order to maximize administrative convenience) and limiting the nominal asset threshold (in order to avoid understating income and to retain proper control over company assets). In addition, many companies are subject to restrictions, including those propounded by the SEC, the Department of Defense, banking, insurance, and other regulatory bodies, that govern a company's minimum capitalization threshold. Moreover, nominal value assets are often short-lived and frequently replaced. Hence, the adoption of a de minimis asset "expensing" rule would likely meet the "clear reflection of income" standard under a "regular and recurring" exception to capitalization. TEI believes that it would be beneficial for the IRS to consider adopting a safe harbor permitting taxpayers to deduct the cost of nominal value purchases and to rely on the taxpayer's business determination of what constitutes a "nominal" value asset. (35) The adoption of such a standard would reduce taxpayer and IRS administrative burdens, formalize current administrative practices, and provide an oversight mechanism to ensure greater consistency and adherence to such practices.

Conclusion

Tax Executives Institute appreciates this opportunity to present our views on Announcement 2002-9, relating to guidance on the treatment of various expenditures under section 263(a), and we look forward to commenting on the proposed rules when released. These comments were prepared under the aegis of TEI's Federal Tax Committee whose chair is Mitchell S. Trager. If you should have any questions, please do not hesitate to call either Mr. Trager at 404.652.2690, or Jeffery P. Rasmussen of the Institute's legal staff at 202.638.5601.

(1) Indeed, concern about the excessive scope and lack of administrable standards in the circuit court's opinion in National Starch v. Commissioner (subsequently restyled INDOPCO v. Commissioner) prompted TEI to submit an amicus curiae brief on the appeal to the United States Supreme Court. TEI urged the court to reaffirm the separate and distinct asset test and reject a significant future benefit standard.

(2) See, e.g., Notice 96-7, 1996-1 C.B. 359.

(3) See BNA Daily Tax Report No. 152, G-2 (August 8, 2001).

(4) In addition, to the extent the taxpayer's treatment of expenditures is consistent with the proposed rules, the taxpayer's treatment of such costs in prior years should not be challenged during the notice-and-comment period. See Chief Counsel Notice CC-2002-021 (March 15, 2002) ("The Service 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 related to the acquisition, creation, or enhancement of intangible assets or benefits.").

(5) Announcement 2002-9, 2002-7 I.R.B. 536 (emphasis added).

(6) Id. at 537.

(7) In connection with the new proposed rules under section 263(a), the government should clarify Treas. Reg. [section] 1.4611(a)(2)(i), which refers to "a liability that relates to the creation of an asset having a useful life extending substantially beyond the close of the taxable year incurred through capitalization...." (Emphasis added.)

(8) Announcement 2002-9, 2002-7 I.R.B. 536, 537.

(9) Id.

(10) Id.

(11) Id.

(12) A capitalized payment would be subject to amortization over the period benefitted by the contract. Thus, a payment that creates or enhances a 36-month contract should be amortized over that period of time.

(13) As explained in footnote 12, any capitalized payment should be amortized over the period benefitted by the contract.

(14) As a practical matter, revenue agents and coordinated industry case taxpayers that are subject to continuing examination frequently agree on threshold dollar amounts that determine the scope of the agent's review of a taxpayer's capitalization of tangible assets and other expenditures. The agreements are informal, taxpayer-specific, and expedite the examination process. We believe that a similar informal process should be encouraged in respect of intangible asset costs or benefits. In other words, a one-size-fits-all de minimis expenditure threshold will increase compliance burdens for many taxpayers and correspondingly expand the scope of the IRS's administrative review. Taxpayers and the IRS alike will benefit from a more flexible approach based on the taxpayer's financial accounting reporting threshold.

(15) Announcement 2002-9, 2002-7 I.R.B. 536, 538.

(16) 52 T.C. 850 (1969). The decision states that no deduction is permitted under section 162 for the lease cancellation payment.

(17) Announcement 2002-9, 2002-7 I.R.B. 536, 537-538.

(18) See also Rev. Rul. 98-25, 1998-1 C.B. 1998 (expenditures to replace a leaking underground storage tank that is filled completely are immediately deductible.)

(19) Announcement 2002-9, 2002-7 I.R.B. 536, 538.

(20) Id.

(21) Id.

(22) Id.

(23) The rules regarding capitalization of compensation costs in other areas would be unaffected. For example, taxpayers would still be required to capitalize (i) the direct labor costs for self-constructed capital assets and (ii) inventory costs required to be capitalized under section 263A.

(24) Such a position would be consistent with the decisions in, for example, Wells Fargo v. Commissioner, 224 F.3d 874 (8th Cir. 2000), and PNC Bancorp, Inc. v. Commissioner, 214 F.3d 179 (3rd Cir. 2000).

(25) The definition of "regular and recurring" costs will be important. One possible definition is, as follows: "Costs incurred in regular and recurring transactions in the ordinary course of the trade or business. In general. Notwithstanding any other provision of this subsection, a taxpayer will not be required to capitalize costs, even though attributable to the creation of an asset or an identifiable portion of an asset with a useful life of 12 months or more, where such costs are incurred in the ordinary course of the taxpayer's trade or business and can reasonably be expected to recur regularly. Costs are reasonably expected to recur regularly if it is reasonable to believe that costs of a similar nature will be incurred in succeeding taxable periods without significant declines in the aggregate amount of such expenditures from year to year so that no material distortion of the taxpayer's taxable income over the life of the taxpayer's business would be expected to result from their deduction."

(26) The ANPR states that the rule "would require a taxpayer to capitalize transaction costs that facilitate the taxpayer's ... `restructuring' ... of a business entity ..." Hence, the term "restructuring" of a business entity seemingly relates to restructuring the capital of the entity rather than process improvement or re-engineering costs. The comments in the text are based on that assumption. In TEI's view, business process re-engineering costs should generally be deductible because the benefit of reduced operating costs is generally realized immediately and any "future benefit" is incidental. See Rev. Rul. 2000-4. To the extent the government believes that a "significant future benefit" standard for capitalization should be adopted and requires capitalization of such costs, it should also adopt a standard amortization period of say, 60 months. In the absence of a general amortization period, there will be significant controversy over the economic life of such amorphous "benefits."

(27) The IRS adopted a similar rule to minimize controversy over the treatment of package design costs. See Rev. Proc. 97-35, 1997-2 C.B. 448.

(28) Indeed, in its appellate brief in the case, the government conceded the deductibility of legal expenses incurred by the target company prior to the date of the agreement (July 22, 1991).

(29) 1999-1 C.B. 998.

(30) Alternatively, the date the Board of Directors of the target approves an acquisition could be considered as the line of demarcation between investigatory and facilitative expenditures.

(31) Announcement 2002-9, 2002-7 I.R.B. 536, 539.

(32) See Commissioner v. Lincoln Savings & Loan Association, 403 U.S. 345 (1971).

(33) See, e.g., Thor Power Tool Co. v. Commissioner, 439 U.S. 522 (1979).

(34) A book-tax conformity rule would engender significant policy and administrative issues as well as taxpayer compliance burdens on subsequent changes in financial accounting methods, regardless of whether the changes are initiated voluntarily by the taxpayer or as a result of changes in financial reporting practices mandated by the SEC, FASB, or a regulatory body. We do not believe that tax policy and administrative rules should be subject to these additional variables.

(35) An anti-abuse rule may be necessary to prevent vendors or purchasers from intentionally fragmenting invoices or otherwise abusing a de minimis expenditure rule. In TEI's view that is the underlying principle vindicated in Alacare Home Health Services, Inc. v. Commissioner, 81 T.C.M. 1794 (2001).
Contributing to the development of TEI's comments were:

George G. Bauernfeind of Humana, Inc.
Daniel P. Bork of Lexmark International, Inc.
Jennifer L. Bradley of Marriott International, Inc.
Keith R. Brockman of Breed Technologies, Inc.
Philip G. Cohen of Unilever United States, Inc.
John C. Cresham of Freddie Mac
Eileen D. Frack of Kimberly-Clark Corporation
David D. Gillman of Telephone & Data Systems, Inc.
Gary P. Hickman of Oldcastle, Inc.
Julianne V. Maggio of GE Capital Corporation
John S. Manning of Lockheed Martin Corporation
Victoria D. McInnis of General Motors Corporation
Michael J. Nesbitt of Paychex, Inc.
Lisa Norton of Amazon.com
John P. Orr, Jr. of Finlay Fine Jewelry
Steven Solinga of Unilever United States, Inc.


Important CPE/CLE Information

Boards of Accountancy. Tax Executives Institute is registered with the National Association of State Boards of Accountancy (NASBA) (Sponsor No. 103086, Exp. 1/01/03). TEI is also registered with the following boards of accountancy:

Illinois (#158-000651, Exp. 12/31/2002); New Jersey (#160, Exp. 12/31/2002); New York (000265, 9/1/99-8/31/02); Ohio (P0087); Pennsylvania (PX613L); Texas (#3512)

Continuing Legal Education. The Institute is registered in the following states as a sponsor of continuing legal education programs:

California--Approved provider status from September 1, 1999 to August 31, 2002. New York--Approved provider status from September 1, 1999 to August 31, 2002. Kentucky--2002 52nd Midyear Conference--11.5 credit hours; 2001 56th Annual Conference--15.5 credit hours; 2001 51st Midyear Conference--19.25 credit hours. Minnesota--2002 52nd Midyear Conference--11.5 credit hours; 2001 56th Annual Conference--12.25 credit hours; 2001 51st Midyear Conference--11.5 credit hours. Ohio--2002 52nd Midyear Conference--14.5 credit hours; 2002 Audits & Appeals Seminar--11.75 credit hours; 2001 56th Annual Conference--15.5 credit hours; 2001 51st Midyear Conference--14.75 credit hours; 2001 Audits & Appeals Seminar--13 credit hours. Oklahoma--2001 56th Annual Conference--18.5 credit hours; 2001 51st Midyear Conference--23 credit hours. Pennsylvania--2002 52nd Midyear Conference--11.5 credit hours; 2001 56th Annual Conference--15.5 credit hours; 2001 51st Midyear Conference--17.5 credit hours. Wisconsin--2001 56th Annual Conference--18.5 credit hours; 2001 Advanced International Tax Course--35 hours. Alabama--2002 52nd Midyear Conference--28.8 credit hours; 2001 56th Annual Conference--15.5 credit hours; 2001 51st Midyear Conference--19.2 credit hours.

Note: TEI provides a continuing professional education form for each registrant at its conferences, courses, and seminars, which should be completed at the conclusion of the program and returned to the TEI Registration Desk for verification and signature. A copy of the form is retained and filed at TEI headquarters.

Tax Executives Institute and TEI Education Fund accord to participants of any race, color, creed, sex, or national ethnic origin all the rights, privileges, programs, and activities generally accorded or made available to participants at their programs, courses, and other activities.

Please note: TEI and TEI Education Fund programs are presented for the benefit of TEI members and others who work in corporate tax departments; private practitioners may not register for the programs.
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Publication:Tax Executive
Date:May 1, 2002
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Previous Article:Comments on operation of Taxpayer Advocate's office: March 27, 2002.
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