Notice 96-7: request for comments on further capitalization guidance.
Proper matching of income and expense in order to clearly reflect income has been a source of contention between taxpayers and the government since the inception of the income tax. One recurring source of that friction is the requirement that proper distinctions be drawn between capital expenditures and deductible ordinary and necessary business expenses. The Supreme Court's decision in INDOPCO v. United States(1)(*) - which employed expansive, amorphous language to adjudicate a narrowly circumscribed set of facts - has sparked another cycle of controversy.
Indeed, despite frequent public assurances from the IRS National Office that "INDOPCO did not change the law regarding capitalization,"(2) agents have seized upon that decision's reference to "future benefits" to support novel capitalization theories. In many cases, agents have distended the Supreme Court's decision, casting aside well-settled law and practice supporting the deduction of many business expenditures. In some instances, agents have sought to undo methods of accounting approved by the National Office for a specific taxpayer. Regardless of the authority cited - whether sections 263 or 263A or, more baldly, INDOPCO - the same burdens are imposed on taxpayers: to produce reams of information replying to information document requests and to defend against unwarranted proposed adjustments.
Tax Executives Institute has monitored these developments and raised continuing concerns during annual liaison meetings with officials of the Department of the Treasury and Internal Revenue Service. In Notice 96-7,(3) the IRS invited public comment on the approaches it should consider to address issues raised under sections 162 and 263 particularly in light of INDOPCO. In response to that invitation, TEI submits the following analysis and list of issues that should be addressed to clarify that expenses incurred are generally deductible. Without guidance on these and other issues not addressed herein (for example, the need for further clarification of the scope of deductible environmental remediation expenditures), there will likely be protracted and continuing disputes between taxpayers and the government. We shall be pleased to discuss these issues in greater detail.
Tax Executives Institute (TEI) is the principal association of business tax executives in North America. The Institute's approximately 5,000 members represent more than 2,700 of the largest companies in the United States and Canada. 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.
TEI members 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 training of our members enable us to bring an important, balanced, and practical perspective to the need for guidance on the deductibility or capitalization of expenditures in the aftermath of the INDOPCO decision.
A. The Need for
Since INDOPCO was decided, the IRS has issued several helpful rulings limiting or explaining the application of this decision to certain expenses. For example, in Rev. Rul. 92-80, the IRS held that advertising expenses are deductible notwithstanding the presence of some future effect on business activities.(4) The future benefit of advertising in nearly every instance is subsumed by the current benefit. In Rev. Rul. 94-12, the IRS held that incidental repairs continue to be deductible because INDOPCO did not "change the fundamental legal principles for determining whether a particular expenditure can be deducted."(5) Similarly in Rev. Rul. 94-38, the IRS held that soil remediation and groundwater treatment expenditures continue to be deductible.(6)
Nonetheless, emboldened by INDOPCO, revenue agents continue to raise capitalization issues outside the narrow scope of that decision. If the IRS does not limit through advance guidance the scope of the application of INDOPCO, the number of cases in controversy will flood all levels of issue resolution (Examination, Appeals, and litigation). Resolving these controversies will consume a significant amount of time and resources for taxpayers, the IRS, and the courts and likely will be counterproductive to the IRS's goal of audit currency. Indeed, a recent GAO report summarizing data from the IRS's CENTAUR issue tracking system documents that capital expenditure issues accounted for 42 percent of the disputes in Appeals as of September 1994.(7 ) Those numbers are likely to increase, though, because of the continuing lag between examination cycles involving INDOPCO issues and their resolution, especially for large-case taxpayers.
B. Private Letter Ruling
Notice 96-7 reminds taxpayers that they may obtain private letter rulings concerning the deductibility or capitalization of specific expenditures. The IRS requests comments on whether that process may be improved to facilitate advance resolution of these issues.
TEI questions whether the IRS can or should modify the private ruling process in order to address capitalization issues separately from other forms of private rulings. The limitations of the private letter ruling process suggest that private rulings are no substitute for published guidance.
The first limitation is the lack of precedential value of private letter rulings under section 6110(j)(3). This limitation protects the government from having taxpayer-favorable private rulings cited against its interest by anyone other than the affected taxpayer. On the other hand, taxpayer-adverse private rulings, while not strictly precedential, often achieve the same result as a published ruling since taxpayers must decide whether to comport themselves with the reasoning and result of the ruling, or - should the issue arise during the course of their own examination - challenge the ruling's analysis. Thus, the lack of precedential value in private rulings creates a perception (if not the reality) that the private ruling process is more calibrated in favor of the government than the public ruling process.
The rationale for limiting the precedential value of private rulings is plain: the review process for private letter rulings is attenuated compared with that for published guidance. Specifically, private rulings are reviewed and approved at the level of the Branch Chief of the Chief Counsel's Office, while public rulings are often reviewed at the highest policy levels within the IRS and the Treasury Department. Hence, under Treas. Reg. [sections] 1.6662-4(d)(iii), published rulings are accorded greater weight for purposes of determining whether substantial authority exists to avoid the imposition of substantial understatement penalties. Moreover, published rulings are given greater deference by taxpayers - especially since the Appeals Branch of the IRS is bound by such rulings and taxpayers may be compelled to litigate to achieve a result at variance with a published ruling.
The second limitation on the private letter ruling process is the diversion of resources - in terms of time and money - for both taxpayers and the government. Obtaining a private letter ruling generally requires months if not years, plus a significant commitment of taxpayer resources. As a result, taxpayers seek private letter rulings only (i) where a complex transaction is involved (and then only for those transactions for which consummation of the transaction may be deferred pending the receipt of a favorable ruling) or (ii) where the tax dollars at stake are significant but for which the timeliness of a ruling is not essential.
Matters loosely referred to as INDOPCO issues, however, frequently involve expenditures for items that are not attributable to discrete transactions, are generally not segregated for financial accounting purposes, and are not deferred (or deferrable) until a ruling is obtained. Increasingly, INDOPCO issues derive from expenditures pertaining to normal, day-today operating expenses that have been challenged and reclassified by revenue agents as capital expenditures. Typically, such day-to-day operating expenses are reviewed for proper tax treatment only during the course of the taxpayer's return-preparation process. Given the time necessary to develop the facts, research the legal issues, draft the ruling request, respond to government requests for additional information, and await a government ruling, the private ruling process will not be helpful or expedient in resolving issues; taxpayers often cannot even imagine that an issue exists until a revenue agent raises it because in many cases the expenditure has been routinely deducted and never challenged.
Hence, private rulings determining the deductibility or capitalization of expenditures are more likely to arise as technical advice memoranda. In that context, the issue that both revenue agents and taxpayers must assess before seeking guidance is whether the benefits obtained from invoking the ruling process outweigh the time and money required to resolving an issue. Although there will always be individual cases where the expenditures are of sufficient magnitude to justify resort to the technical advice process, the majority of cases do not rise to that threshold. Notwithstanding that the tax dollars at stake in individual cases may be nominal, the degree of controversy surrounding a particular issue may be great, especially where it is present in a large number of cases. Compelling numerous taxpayers to seek guidance on the same issue or injecting the National Office into the examination of the same issue in multiple cases is neither wise nor efficient.
Rather than permit the legacy of INDOPCO to evolve slowly through private letter rulings, technical advice memoranda, or litigation, TEI urges the IRS and Treasury to publish general guidance clarifying the tests for capitalization or deduction of particular types of expenditures. Specifically, we urge the government to continue to define the boundaries of the capitalization guideline articulated in the INDOPCO decision, including its application to the issues identified in parts V and VI below. The greatest benefit to the greatest number of taxpayers - and to the government - will be achieved through the issuance of general guidance. Where ruling guidelines or principles are extant within the Chief Counsel's office (but unpublished), we suggest that such guidelines or principles be publicized in order that taxpayers may have more certainty in properly preparing their tax returns.
C. Recordkeeping Burdens
Increasingly, agents have taken the position that a particular project or expenditure results in some long-term future benefit - no matter how amorphous or attenuated that benefit might be. To develop a proposed adjustment under INDOPCO, agents seek records for associated costs - often employee compensation - that are routinely treated as period expenses and deducted in the year incurred. Since most companies do not require employees to maintain daily time sheets or records regarding time spent on specific projects or assignments, the salary, benefits, and associated costs often do not exist in a form that is retrievable or even recognizable as a "project" expenditure.(8) Should the taxpayer fail to produce "records" in a form that an agent deems acceptable, the taxpayer may face an assertion that it has failed to keep "books and records" in accordance with Treas. Reg. [section] 1.6001-1(a) because, after all, "INDOPCO did not change the law of capitalization." To avoid such a charge, taxpayers will be forced to devote significant time and effort to reconstruct an allocation or apportionment of time and related costs to a particular project or assignment to defend against such an adjustment.
In addition, the conclusory nature of the "future benefit" argument frustrates taxpayers because they are often compelled to undertake a futile search for records that are unlikely to be accepted as persuasive in any event. The INDOPCO argument frequently proffered by revenue agents is illustrated by the following composite of boilerplate language: (1) INDOPCO does not represent a change in law; (2) income tax deductions are a matter of legislative grace; (3) the burden to establish the right to the claimed deduction is on the taxpayer; (4) expenditures providing future benefits are capital in nature; and (5) since any expenditure might produce a future benefit (though not a "significant" one), an adjustment is hereby proposed for "X" - where "X" represents whatever expenditures the agent identified in the information document request and deems to provide a future benefit.
Since under "normal" tax and financial accounting rules, period expenses are deducted in the year in which they are incurred, taxpayers face an impossible task: they must provide books and records to establish the costs that relate to a newly contrived capital asset. As a result, even more disturbing than the increased burden of producing books and records is the specter of penalties on taxpayers for failing to provide documentation and proper support for recurring expenses that in the agent's view produce a future benefit. Adding further insult to injury, an agent's information document request or notice of proposed adjustment often invites the taxpayer to provide information to establish a useful life over which to amortize these newly contrived assets.
To defend against such adjustments, companies would be required to compel employees to complete daily time sheets and undertake other accounting procedures or system modifications to identify and properly allocate all such periodic expenses even though the proper treatment in nearly every case is that the expenditure should be deducted. Although it is theoretically possible to allocate wages, benefits, training expenses, and other costs that companies incurred on ordinary day-to-day business activities, the recordkeeping costs would be enormous and likely exceed the revenue to be collected. Hence, the administrative costs of conceptual rigor are too great. Asking companies to disprove a negative, i.e., that there is no "significant future benefit" arising from an expenditure, is nearly impossible. More important, the recurring nature of periodic expenses, coupled with the incidental nature of the future benefit, compels the conclusion that income is more clearly reflected by permitting a current deduction.
Summary of Applicable Law
A. Ordinary and
Taxpayers are permitted deductions under section 162 for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. Although not defined in the Internal Revenue Code, courts have interpreted "ordinary" to mean any expenditure that is common and accepted in a particular industry or line of business.(9) The term necessary" imposes only the minimal requirement that the expense be helpful or appropriate for the development of the taxpayer's business.(10)
B. Capitalization and the
Under section 263, taxpayers may not claim deductions for expenditures considered to be capital. Section 263(a)(1) provides that no deduction is permitted for any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate. Under section 263(a)(2), no deduction is allowed for any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made for depreciation, amortization, or depletion. Treas. Reg. [section] 1.263(a)(l)-(b) explains that the cost of capital expenditures are added to the basis of the underlying property and "recovered through depreciation, amortization, cost of goods sold, or adjustments to basis...in accordance with applicable Code sections and regulations."
The purpose of these rules is to achieve a proper matching of income and expense in order to clearly reflect income.(11) The primary criteria for distinguishing whether a cost will be deductible under section 162 or capitalized under section 263 is whether the expenditure adds value, substantially prolongs the useful life of taxpayer property, or adapts property to a new use.(12) Where the expected future benefit is merely incidental(13) or the benefit of an expenditure does not extend substantially beyond the taxable year, the expenditure is generally deductible in the taxable year in which it is incurred.(14)
C. Vague Scope of
Vitiates Its Value;
In INDOPCO, the Supreme Court supplied limited guidance regarding the distinction between capital expenditures and currently deductible expenses: the Court said the future benefit of an expenditure must be more than "incidental."(15) Untethered by any further defining principles, the concept of a more-than-incidental future benefit" as the primary criterion threatens a degree of controversy that may overwhelm the tax system's ability to resolve disputes. The administrative costs of resolving the myriad issues that revenue agents are raising are too great - for the government and taxpayers alike. We recommend, therefore, that the IRS continue to issue general guidance clarifying the fundamental principles of capitalization. Before addressing specific issues on which such guidance would be appropriate, however, we wish to review other tenets of the tax "common law" of capitalization.
D. Regular and
Where an expenditure is regular and recurring, a deduction in the year the expense is incurred will more clearly reflect income since the expense will then be matched with the annual revenues produced by the expenditure. The court in Encyclopaedia Britannica, Inc. v. Commissioner,(16) summarized the view thusly:
Most of the "ordinary," in the
sense of recurring, expenses
of a business are noncapital
in nature and most of its capital
expenditures are extraordinary
in the sense of
nonrecurring .... The distinction
between recurring and
nonrecurring business expenses
provides a very crude
but perhaps serviceable demarcation
capital expenditures that can
feasibly be capitalized and
those that cannot be.
Therefore, the recurring or nonrecurring nature of an expenditure serves as a practical guideline to determine whether an expenditure is to be deducted or capitalized. Indeed, the court in Encyclopaedia Britannica further observed:
If one really takes seriously
the concept of a capital expenditure
as anything that
yields income, actual or imputed,
beyond the period...in
which the expenditure is
made, the result will be to
force the capitalization of virtually
every business expense.
It is a result courts
naturally shy away from....
It would require capitalizing
every salesman's salary,
since his selling activities
create goodwill for the company
and goodwill is an asset
yielding income beyond
the year in which the salary
expense is incurred. The administrative
costs of conceptual
rigor are too great.(17)
Indeed, the failure to take account of the administrative costs associated with capitalization of expenditures and the propensity of agents to ignore the current income produced by recurring expenditures are at the nub of INDOPCO controversies.
E. De Minimis Rule
Both the IRS and the courts have stated that expenditures that result in future benefits do not have to be capitalized if the amount is so small that permitting a deduction does not distort the clear reflection of income. or example, the Court of Claims in Cincinnati, New Orleans & Texas Pacific Ry. v. United States(18) stated that:
where the burden on both
taxpayers and Service to account
for each item of property
separately is great, and
the likelihood of distortion of
income is nil or minimal, the
Code is not so rigid and so
impracticable that it demands
that nevertheless all
items be accounted for individually,
no matter what the
trouble or the onus.(19)
In addition, the IRS has recognized that certain de minimis amounts should be permitted as deductions regardless of future benefits,(20) and as a matter of administrative convenience accepted taxpayers' use of reasonable thresholds.
F. Business Expansion Costs
Expenditures to start up a new business are not deductible currently.(21) Expenditures to expand an existing business (e.g., promotional activities to increase sales(22) or expenditures to develop a new sales territory(21), however, are deductible where the expenditures are to expand an existing business;(24) the business activity contemplated is closely related to the existing business;(25) the expansion does not result in a new or separate entity being formed; and, finally, the expenditures are ordinary and necessary expenses and are not capital in nature.
The IRS has recognized that "recurring costs incurred by a going concern in expanding its business generally are deductible, but the costs of entering a new line of business are capital expenditures."(26) In addition, the Second Circuit's decision in Briarcliff Candy Corp. v. Commissioner(27) provides a welcome level of clarity and rationality for distinguishing expenditures that are deductible in the current year from those that may require capitalization. The Second Circuit agreed with the taxpayer and held that "the facts of this case bring it squarely within the long recognized principle that expenditures for the protection of an existing business ... are ordinary and necessary within the meaning of section 162 and not capital in nature."(28) The court insightfully stated:
Every new idea and every
change of method in making
sales, even in promoting special
sales or developing new
sales territory, do not require
that the expenses connected
with the operation be nondeductible
under [section] 162.
While the quotation taken by
the Commissioner from
Houston Natural Gas that
"an intensive campaign to get
new customers at any time
gives rise to capital expenditures"
may be valid enough if
confined to the facts of that
case, it is not acceptable as
an unqualified general rule.
In fact, expenditures by an
already established and going
concern in developing a
new sales territory are deductible
under [section] 162. Rev.
Briarcliff is merely one example of the well-settled principle of federal income tax law that ordinary expenses of an ongoing business are properly treated as expenses of the current period.(30) Thus, an already established and going concern may deduct ordinary and necessary expenses incurred in the expansion of its existing normal business activity.(31) Expenses that are deductible as costs incurred in the expansion of a business include expenditures by an existing company for the purposes of developing a new sales territory,(32) increasing sales through promotional activities,(33) and developing foreign markets.(34)
Moreover, the legislative history of section 195 confirms Congress's intention that business expansion costs continue to be deductible when incurred in the expansion of an existing business. In relevant part, the reports state:
In the case of an existing
business, eligible startup expenditures
do not include
deductible ordinary and necessary
paid or incurred in connection
with an expansion of the
business. As under present
law, these expenses will continue
to be currently deductible.(35)
In its brief in INDOPCO, the government acknowledged that section 195 recognizes that "expenditures incurred in carrying on or expanding an existing business generally are deductible under Section 162(a), while expenditures incurred in creating a new business and expenditures incurred by a going concern in entering a new line of business are capital expenditures."(36)
In the course of its deliberations over the enactment of two separate statutory provisions modifying the treatment of certain expenditures, Congress has seemingly rejected the notion that expenditures incurred for self-created intangible property should be capitalized.
For example, in 1986 when Congress enacted the uniform capitalization provisions of section 263A, the Senate Finance Committee's report stated that the section was not designed to change the current determination of whether an expenditure creates a separate and distinct asset with a useful life substantially longer than the current taxable year.(37) Accordingly, section 263A does not apply to the costs of creating an intangible item such as goodwill if such costs are currently deductible under present law.(38)
Section 197 is similarly limited and does not extend to self-created intangibles. The legislative history of that 1993 legislation states, "it is also believed that there is no need at this time to change the Federal income tax treatment of self-created intangible assets, such as goodwill that is created through advertising and other similar expenditures.(39) During the legislative process leading to the enactment of section 197, it was stated that "some costs that are paid or incurred to create, maintain, or enhance the value of certain intangible assets may be deducted as ordinary and necessary business expenses for the year that the costs are paid or incurred."(40) By way of example, the Joint Committee on Taxation cited Treasury regulations for the proposition that "advertising expenses generally may be deducted for the year paid or incurred."(41) Likewise, costs incurred to train employees generally may be deducted for the year such costs are paid or incurred even though the training results in a more knowledgeable or valuable workforce.(42) Finally, "although taxpayers generally must capitalize the costs of acquiring intangible assets from another person (such as the cost of acquiring a customer list or goodwill), taxpayers generally may deduct the costs incurred to develop or maintain such intangible assets."(43)
Any attempt by revenue agents to require the capitalization of the costs of internally developed intangible assets is inconsistent with existing statutes, congressional intent, and case law. If broad sweeping changes in the administration of this country s income tax system are intended, they should result from congressional directives rather than unfettered administrative theorizing.
A. Training and Relocation
The just-in-time manufacturing technique may involve significant workforce training costs and consulting fees relating to training both management and the workforce in general. As we stated in our September 21, 1995, letter (copy attached), TEI believes that the workforce training and related consulting costs associated with the adoption of just-in-time manufacturing techniques are fully deductible, just as costs associated with training employees to perform their jobs within an existing business are fully deductible.(44) Just-in-time manufacturing involves ordinary and necessary training to implement efficient management and manufacturing practices, unlike the extraordinary training costs described in Cleveland Electric Illuminating Co v. United States,(45) where the costs were incurred to facilitate the issuance of governmental licenses.
Expenditures to implement just-in-time manufacturing techniques are also likely deductible as research and experimental expenditures under section 174. Under section 174, research or experimental expenditures means expenditures that represent research and development costs in the experimental or laboratory sense(46) - i.e., if they are for activities intended to discover information that would eliminate the uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product.(47) The term generally includes all costs incident to the development or improvement of a product. The term "product" includes any pilot model, process, formula, invention, technique, patent, or similar property.(48) When manufacturers undertake to implement just-in-time techniques and processes, there is no certainty that their products or processes will be improved. As a result, the implementation costs for just-in-time manufacturing are experimental costs incurred to discover information that would eliminate the uncertainty concerning the development or improvement of a product.
2. Costs for Total Quality
Many companies expend significant sums for consultants' fees, employee salaries, supplies, etc., to maintain or improve the quality of their products or services. Some of the costs relate to wholly internal company programs designed to improve the efficiency and effectiveness of organizational or managerial processes, to translate concepts developed in manufacturing process environment to the office, to re-engineer and streamline office or manufacturing procedures, or to continuously improve the manner in which the company does business. Occasionally, these costs involve payments to employees or consultants to conduct formal classroom-type or on the-job training. More often, the expenditures involve ordinary salary payments to employees for time spent engaged in mutual problem-solving sessions ("brainstorming" or "bench-marking" sessions). The beneficiaries of the total quality management (TQM) training include a company's internal and external customers.
Although company TQM programs have become both more popular and visible recently - owing in part to the need to respond to increased global competitive pressures and in part to publicity about business trends - TQM programs represent a sound business practice that has been employed for many years, albeit either as a less rigorously developed conceptual matter or under a different rubric such as quality control, process control, employee training, or, the employee suggestion program, In effect, TQM programs enable companies to capture the creative ideas generated by employees while performing their day-to-day job duties. Given the intense global competition that faces many businesses, and the resulting need for continuous improvement in efficiency and cost reduction, the TQM programs will persist in one form or another for many years. As important, the attendant training costs will be continuous or recurring.
TEI believes that costs incurred for TQM programs are ordinary and necessary business expenses and deductible currently under section 162 for several reasons. First, the primary purpose of the TQM training and program is to permit the employees to perform current duties in a more efficient fashion. In addition, the expenditures are recurring in nature. Moreover, any "future benefits" derived from the expenditures - to the extent particularized benefits can be isolated, quantified, and attributed - are inseparable from the current benefits derived from having a better-trained, better-informed, workforce performing the same or similar tasks as before the TQM training. Hence, the expenditures are deductible as ordinary and necessary educational expenses under Treas. Reg. [sections] 1.162-5 and as recurring expenditures under the Encyclopaedia Britannica test.
3. Employee Relocation
Expenses incurred to relocate employees incident to a transfer have been deductible under section 162 for many years as ordinary and necessary business expenses. Under the uniform capitalization regulations, however, service costs that either (a) directly benefit or (b) are incurred by reason of the performance of production or resale activities of a taxpayer may be capitalized.(49) The uniform capitalization regulations are thus consistent with cases requiring capitalization of wages allocable to the construction of fixed assets.(50) Where relocation costs are unrelated to the construction of fixed assets, however, the costs are deductible recurring expenses.
Notwithstanding the lack of precedential value of private letter rulings, some revenue agents have asserted that the reasoning in Private Letter Ruling 9426004 supports the capitalization of relocation costs incurred as part of a company-wide restructuring. Thus, although the relocation costs were not related to, or by reason of, the engineer's activities in the construction of fixed assets or production activities, agents have argued that the company's restructuring renders the costs nondeductible. Private Letter Ruling 9426004, which is concerned generally with proper treatment of construction workers' "unclassified time" however, is wholly, unrelated to employee relocation costs. In other words, payments for relocation costs may in fact constitute taxable compensation to the employees, but such payments are not a fundamental component of the employed compensation subject to capitalization or allocation to construction activity.(51) Private Letter Ruling 9426004 notes that certain general and administrative expenses attributable to the performance of services that do not directly benefit, or are not incurred by reason of a particular production activity, are not required to be capitalized.(52)
Treas. Reg. [sections] 1.263A-l(e)(4)(ii)(B) permits the deduction of costs incurred by reason of the exercise of "overall management or policy guidance." Although expenses associated with relocation is listed in the examples of costs "generally allocated among production or resale activities," TEI submits that indirect expenses of relocation can be either deductible or capitalizable depending upon the reason for the relocation. Where the costs are unrelated to the construction of a particular fixed asset or construction or production activities generally, however, they are deductible recurring expenses.
B. Business Expansion
1. Customer Service
These expenditures, composed typically of employee salaries, benefits, legal expenses, and consultants' fees, are costs associated with the development and negotiation of service contracts with customers, the term of which may or may not exceed one year. When the costs are incurred to develop and negotiate an agreement, the term of a particular customer's agreement is typically unknown until the execution of the agreement. Depending upon the type of agreement, the nature of the services provided, the relative bargaining power of the parties, the degree of standardization (or customization) of the services provided, and other factors, the time involved in negotiating and developing the contractual terms for specific customers may range from minutes to months. In all cases, however, the business purpose of these expenditures is to maintain or expand existing lines of business services.
The expenses associated with these selling activities, especially those incurred for wages and benefits for employees, are part of, and inseparable from, recurring day-to-day activities incurred to expand an existing business. Hence, such expenses should be deductible under the rationale set forth in Briarcliff Capitalization of the expenses would not necessarily reflect income more clearly; requiring companies to account for these costs separately in respect of each potential customer service agreement would, however, impose a severe administrative burden especially where there are substantial numbers of customers. Concededly, service agreements with a term in excess of one year may occasionally be executed. At any one time, however, employees are likely to be involved in negotiation with a number of separate customers or potential customers and the terms of the contracts will vary by customer. TEI believes that this type of expense, as a routine and ongoing part of a company's marketing efforts, are made to expand an existing business and, hence, indistinguishable from deductible advertising expenses. Should companies be required to capitalize such expenses, the time spent in unsuccessful negotiations would have to be segregated and the related costs deducted when negotiations cease. In addition, the costs related to the time spent in successful negotiations would be required to be segregated on a contract-by-contract basis with the costs recovered over the period of each separate contract. We believe, however, that any "future benefit" arising from agreements with terms exceeding one year would likely be overwhelmed by the incremental administrative burden of accounting for such costs on an agreement by-agreement basis. Any increased clarity in the reflection of income would be purely theoretical. In such a case, administrative convenience and common sense should prevail to permit continued deductions and obviate additional recordkeeping burdens.
2. New Service
These expenses (typically, again, employee salaries, benefits, legal expenses, consultants' fees, and research and development expenses) relate to the development of new services. New services generally involve an expansion of an existing line of service and, hence, are not start-up costs for a new trade or business. The expenses are incurred for such activities as software development, feasibility studies, and marketing surveys. As such, they are deductible because they are either (1) research and experimentation expenses under section 174 or (2) are of a recurring nature and should be deducted under section 162 in order to reflect income more clearly. Feasibility and marketing studies, the costs of which are deductible under section 263A - the most stringent congressional standard for capitalization - should not be capitalized under INDOPCO. In addition, a substantial administrative burden would be placed on companies to account for these costs in relation to each new service that is not a new trade or business.
C. Recurring Expenses
1. Cellular Telephone Sales
The deductibility of commissions paid to employees and independent sales agents by cellular telephone companies for selling one-year (or shorter), renewable service contracts have been challenged under the nebulous future benefit standard of INDOPCO. The commissions at issue are routine, recurring business expenses that do not necessarily secure significant future benefits. In the typical case, a commissioned sales agent is required to refund commissions received where the customer terminates cellular telephone service within six months of inception of the service. Thus, the commissions are properly viewed as being paid to agents to secure the opportunity for cellular telephone companies to serve a customer. Once the customer, whose agreement may or may not be renewed for additional terms, is secured, no further services are expected from or provided by the selling agent. Revenue agents are asserting that the commission is paid to secure a customer relationship that has a future value beyond the current year and, as a result, the commission must be capitalized and amortized over the expected life of the customer relationship.
The commissions paid by cellular telephone companies are another example of a routine recurring operating expense that might lead to customers' continuing to do business on a long-term basis. The customers, however, are not bound or compelled to do so. Any future benefit from the commission is highly attenuated and indistinguishable from the current benefit and income produced. Under the matching principle, the costs should be deducted when incurred.
2. Product or Process
Many companies have expended significant sums for salaries, supplies, rent, consultants' fees and other costs to meet product or process. quality standards set directly or indirectly by the companies' customers. As a result of intense global competition and the consequent focus on product quality and reliability (or the quality and reliability of a certain business or manufacturing process that produces the product), customers have increasingly prescribed certain standards of quality or reliability that suppliers must meet to be deemed an acceptable supplier.(53) (Often these standards are established by original equipment makers for other manufacturers who supply component parts.)(54) to ensure that the quality levels or reliability standards have been attained, customers increasingly require that a supplier's processes be inspected and certified by an independent, non-governmental body or agency. Companies subject to these certification requirements must show that they meet existing standards and have business processes to ensure continuous improvements in the quality and reliability of their products.
TEI believes that the costs incurred to establish that a company's processes meet or exceed quality or reliability standards are ordinary and necessary business expense$ and deductible currently. The primary purpose of the expense is to permit current product or service sales, and hence the costs are deductible under section 162. Alternatively, many of the costs will be incurred "for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product" and, consequently, deductible as research and experimentation expenses under section 174.
The factors to be considered in determining whether post-acquisition expenses are deductible or capitalizable are the nature of an expense, the purpose for which it was incurred, and whether it is directly related to the assets acquired through the acquisition. Operating expenses, such as those described below, that are incurred post-acquisition do not produce significant future benefits and hence should remain deductible. Unlike outside investment banking, appraisal, legal, and accounting fees, certain printing costs, and payments to acquire the stock or assets of an acquired company, post-acquisition operating expenses are unrelated to the transaction in which the property (including stock) was acquired. Post-acquisition operating expenses generally originate in management's drive to reduce operating costs of the combined businesses.
In most cases, no significant future benefit arises from a post-acquisition expenditure because the costs incurred relate to the termination of unnecessary business arrangements. Indeed, such costs often relate to terminating arrangements or contracts that, left unaltered, would produce otherwise deductible operating expenses. For example, the cost of early termination of a lease will reduce deductible rent expense.(55) Capitalization of costs that reduce operating expenses would be inconsistent with a number of rulings including the most recently published guidance that held that the installation of energy saving devices that avoided costs and reduced future operating costs were deemed not to produce significant "future benefits" that required capitalization.(56)
A. Severance Payments
Severance payments based on services previously rendered are generally deductible under Revenue Ruling 94-77.(57) The ruling states that no inference should be drawn concerning severance payments made in connection with the acquisition of property (including a deemed acquisition of assets pursuant to section 338). The "no inference" statement was seemingly intended to preserve other issues for further study. Regrettably, some revenue agents have seized upon the "no inference' statement as an invitation to capitalize severance payments to terminated employees of an acquired or acquiring company where the terminations occur about the time of the acquisition.
TEI believes that severance payments related to services previously rendered (e.g., a payment of one week of salary for every year of service) constitute deductible compensation payments when made. Since Rev. Rul. 94-77 holds correctly that severance pay is deductible notwithstanding the future benefit of reduced operating costs or increased operating efficiencies arising from a down-sizing, we see no basis for a distinction where the severance payments are incurred coincident with an acquisition.(58) As explained in a recent technical advice memorandum,(59) a deductible expense is not converted into a capital expenditure solely because the expense is incurred as part of the terms of a corporate reorganization. Rather the important consideration in determining the nature of an expenditure for tax purposes is the origin and character of the claim for which the expenditure is incurred.(60) Under the "origin of the claim doctrine," the character of a particular expenditure is determined by the transaction or the activity from which the able event proximately resulted.(61) The purpose, consequence, or result of the expenditure is irrelevant in determining the origin of the claim, and therefore, the character of the expenditure.(62) The technical advice memorandum held that payments made to cancel stock options and stock appreciation rights to effectuate an acquisition did not originate in the acquisition but rather in the employment relationship between the taxpayer and the option holders.(63) Hence, the payments were deductible ordinary and necessary business expenses.
B. System Integration
System integration expenses - costs associated with the bridging and interconnection of computer or telecommunications network systems that neither materially increase the value of the systems nor prolong their useful life - should constitute deductible expenses. Typically the expense is incurred to integrate one computer or telecommunications system into another to achieve operational efficiency. For example, assume Company A is acquired by Company B. Company A has a billing system that interfaces directly with its general ledger to update accounts receivable, inventory, etc. Following the acquisition, Company B decides to continue using Company A is billing system but not the general ledger. Instead, Company B "integrates" Company A's billing system into B's general ledger system by developing the necessary system interfaces and software links to pass data from Company A's billing system into Company B's general ledger.
The expenses of integrating computer networks or software systems are indistinguishable from the expense of relocating assets, which the IRS has held to be deductible.(64) As was the case in Rev. Rul. 70-392, the integration of the systems does not materially change the system's characteristics, add to its value, or prolong its life. The fact that the integration occurs as a consequence of an acquisition is irrelevant; the cost is attendant to the company's day-to-day business operations. Notwithstailding any attenuated "future benefit" that may arise from operational efficiencies, these expenses should remain deductible.
C. Contract Terminations
In order to reduce future operating expenses and consolidate the number of physical locations following an acquisition, companies often incur fees and charges to terminate leases or contractual commitments. Expenses incurred in connection with the termination of facility and property leases or contracts in order to reduce future operating costs should be deductible, notwithstanding that these costs were incurred as part of integrating the operations of an acquired company. A determination of whether a payment to terminate a contract must be capitalized or deducted depends on the origin and character of the payment.(65) Where the payment is made solely for termination of a contract, not in exchange for a new or modified contract that will bring the company long-term benefit, the payment is deductible.(66) The fact that the contract is terminated as a consequence of an acquisition is irrelevant. If the terminated contract related to the company's business operations, the payment is deductible.(67)
D. Decommissioning Costs
Decommissioning costs may be defined broadly as any expense incurred to eliminate duplicative trade or business operating assets, e.g., duplicate mainframe computers, accounting systems, telephone systems, etc. The disposition of trade or business assets generally gives rise either to abandonment losses under section 165 or deductible losses under section 1231. For leased assets, a lease or contract termination payment is generally deductible under section 162. Often such costs may be incurred as part of a post-acquisition plan to reduce continued operating costs. No new asset or other future benefit is generally obtained as a result of the cost reduction. As a result, the origin of the expense is the drive to reduce operating costs. TEI believes that such costs are deductible under section 162.(68)
Recovery of Capital
Under the Code and regulations, expenditures must be properly classified as between capital and expense.(69) When an expenditure results in the creation of an asset having a useful life that extends substantially beyond the close of the taxable year, such an expenditure may not be deductible, or may be deductible only in part, for the taxable year in which made.(70) Capital expenditures are subsequently recovered through depreciation, amortization, cost of goods sold, as an adjustment to basis, or otherwise, at such time as the property to which the amount relates is used, sold, or otherwise disposed of by the taxpayer.(71) Among the applicable Code sections is section 167, which permits "a depreciation deduction for the exhaustion wear and tear . . . (1) of property used in the trade or business, or (2) of property held for the production of income."(72) Except as provided by statute, depreciation deductions for tangible property are determined under section 168. Certain intangible assets acquired in connection with an acquisition of a trade or business are generally amortizable under section 197, and other intangible assets are amortizable under section 167.
The current degree of controversy concerning capitalization issues is as much about the period and method for recovering a capitalized cost as it is about whether a particular expenditure is capital in nature. All too often, revenue agents seek the most disadvantageous result to taxpayers. Hence, agents generally propose that the longest-lived property with the slightest transactional or business connection to the expenditure is the property "improved" by a capitalized expenditure. Indeed, the quest seems to be to relate the expenditure to an intangible asset (or to create a new intangible asset) with an indefinite life for which no amortization will be permitted under Treas. Reg. [sections] 1.167(a)-3.
In providing guidance, the National Office should instruct its revenue agents to consider what period or periods are most benefitted by a particular expenditure. Thus, where an expenditure relates to the production of current income notwithstanding some incidental ensuing future benefit), the proper period for deducting an expenditure is the current period. Where an expenditure relates to income earned in the past (eg., compensation for past services,(73) legal fees,(74) compensatory damages,(75) and environmental clean-up costs incurred in the ordinary course of business(76), the expenditure similarly should be deducted currently. Where the IRS determines that the future benefit of an expenditure is significant enough to warrant capitalization, the next step must be to provide guidance ensuring that the cost is properly associated with an identifiable asset and recovered in the proper period and within a reasonable time. The alternative - creating new assets or associating expenditures with assets possessing indefinite or excessively long lives - will ensure protracted and continuing controversies between taxpayers and the government.
Among the reasons that taxpayers welcomed Rev. Rul. 94-38 (concerning environmental clean-up costs) is that - not only did it provide guidance that the groundwater clean-up expenditures are deductible - it provided a reasonable and certain life over which to recover the cost of the capitalized groundwater treatment facilities. Similarly, if under extraordinary and unusual facts and circumstances an intangible item is determined to be capital - say, for example, the employee training expenditures in Cleveland Electric Illuminating Co. v. United States,(77) which permitted the taxpayer to license its engineers to operate a nuclear power plant - the IRS should consider providing guidance that the expenditures relate solely to the existing workforce and are recoverable either (1) over a reasonably short amortization period of up to, say, 36 months or (2) as current employees retire or otherwise terminate their employment.(78) The circumscribed amortization period reflects the likelihood that the value of expenditures for intangibles such as this diminishes rapidly. At a minimum, the National Office should require that agents undertake an analysis to define the recovery period and method for every capitalized expenditure that purports to give rise to an intangible asset. Moreover, the guidelines for agents (and taxpayers as well) should point out that expenditures for such assets rarely give rise to an asset with an indefinite life.
While many of the expenditures illustrated in the foregoing examples are not novel, the conflict over whether the costs are currently deductible is. Consequently, TEI is concerned that revenue agents have seemingly taken it upon themselves to extend the decision in INDOPCO to expenditures long considered deductible. Hence, we urge the IRS and Treasury to continue issuing general guidance clarifying that the INDOPCO decision did not affect the current deductibility of many expenses. We shall be pleased to discuss our comments and examples in more detail.
TEI's comments were prepared under the aegis of its Federal Tax Committee, whose chair is Bruce H. Barnett of Cargill, Inc. If you have any questions concerning these comments, please call either Mr. Barnett at (612) 742-6778, or Jeffery P. Rasmussen of the Institute's professional tax staff at 202) 638-5601.
(1) INDOPCO v. United States, 503 U.S. 79 (1992). (2) See, e.g., Rev. Rul. 94-12, 1994-1 C.B. 36. (3) 1996-6 I.R.B. 22. (4) 1992-2 C.B. 57. (5) 1994-1 C.B. 36. (6) 1994-1 C.B. 35. (7) Tax Administration: Recurring Issues in Tax Disputes Over Business Expense Deductions, United States General Accounting Office (GAO/GGD-95-232, Sept. 26,1995). (8) Even for those companies that do require time sheets, the recordkeeping is likely limited to (i) a few departments within the company e.g., the legal department) and (ii) cursory descriptions of the work performed. Where extant, in-house time sheets are often not comparable to the more detailed descriptions maintained to support invoices from fee-based consultants. (9) An ordinary expense means one that is "normal, usual, or customary." Deputy v. Dupont, 308 U.S. 488, 495 (1940). (10) Welch v. Helvering, 290 U.S. 111, 113 (1933). (11) "Through provisions such as these, the Code endeavors to match expenses with the revenues of the taxable period to which they are properly attributable, thereby resulting in a more accurate calculation of net income for tax purposes." INDOPCO v. United States, 503 U.S. 79, 84 (1992). (12) Treas. Reg. [sections] 1.263(a)-1(b). (13) Amounts paid or incurred for incidental repairs are generally deductible under section 162 even though they may have some future benefit. Rev. Rul. 94-12, 1994-1 C.B. 36. (14) INDOPCO, 503 U.S. at 87. See also Central Texas Savings & Loan Assn v. United States, 731 F.2d 1181, 1183 (5th Cir. 1984). (15) Although the mere presence of an incidental future benefit `some future aspect' - may not warrant capitalization, a taxpayer's realization of a benefit beyond the year in which the expenditure is incurred is undeniably important in determining whether the appropriate tax treatment is immediate deduction or capitalization." INDOPCO, 503 U.S. at 87. (16) 685 F.2d 212, 217 (7th Cir. 1982), reversing and remanding, T.C. Memo 1982-255. (17) Id. (citations omitted and emphasis added). (18) 424 F.2d 563 (Ct. Cl. 1970). (19) Id. at 572. (20) In General Counsel Memorandum 34959 (July 25, 1972), Chief Counsel's Office recommended that the IRS issue a revenue ruling to permit a taxpayer to deduct small capital expenditures that do not exceed $100 in the year incurred. (21) See Frank v. Commissioner, 20 T.C. 511 (1953); Madison Gas & Electricity Co. v. Commissioner, 633 F.2d 512 (7th Cir. 1980) (expenses incurred to start a new or unrelated business are treated as start-up capital expenses); I.R.C. SS 195 (start-up costs may not be deducted and the taxpayer may elect to amortize these costs). (22) Rev. Rul. 56-181, 1956-1 C.B. 96. (23) Briarcliff Candy Corp. v. Commissioner, 475 F. 2d 775 (2d Cir. 1973). (24) Id.; Rev. Rul. 56-181, 1956-1 C.B. 96. (25) Mid-State Prod. Co. v. Commissioner, 21 T.C. 696 (1954); York v. Commissioner, 261 R2d 421 (4th Cir. 1958). (26) Brief for the Respondent on Petition for a Writ of Certiorari in INDOPCO v. Commissioner, 503 US. 79 (1992) (No. 90-1278), at 14-15,n.6 citing Colorado Springs Nat7 Bank v. United States, 505 F.2d 1185, 1190 (10th Cir. 1974); Carl Reimers v. Commissioner, 211 F. 2d 66, 68 (2d. Cir. 1954)). See also H.R. Rep. No. 1278,96th Cong., 2d Sess. 11(1980). (27) 475 F.2d 775 (2d. Cir. 1973). (28) Id. at 787. (29) Id. at 782 (emphasis added). (30) I.R.C. [sections] 162; Treas. Reg. [sections] 1.162-1(a). See also Allen v. Commissioner, 283 F.2d 785, 790-91 (7th Cir. 1960); Lutz v. Commissioner, 282 F.2d 614, 617, 620 (5th Cir. 1960); Van Iderstine Co. v. Commissioner, 261 F.2d 211,213 (2d Cir. 19.58); Commissioner v. Surface Combustion Corp., 181 F.2d 444, 447 (6th Cir. 1950); United States v. E.L. Bruce Co., 180 F.2d 846, 848-49 (6th Cir. 1950). (31) Briarcliff Candy Corp., 475 F.2d 775 (2d Cir. 1973); York v. Commissioner, 261 R2d 421 (4th Cir. 1958); see I.R.C. [section] 162(a). (32) Briarcliff Candy Corp., 475 F.2d 775 (2d. Cir. 1973). (33) Rev. Rul. 56-181, 1956-1 C.B. 96. (34) Rev. Rul. 64-42, 1964-1 C.B. 86. (35) H.R. Rep. No. 1278, 96th Cong., 2d Sess. 11 (1980); S. Rep. No. 1036, 96th Cong., 2d Sess. 12 (1980) emphasis added). (36) Brief for the Respondent, INDOPCO, at 37 n.21. (37) S. Rep. No. 313, 99th Cong., 2d Sess. 141 (1986). (38) Id. (39) H. Rep. No. 11, 103d Cong., 1st Sess. at 323 (1993). (40) Joint Committee on Taxation, 102d Cong., 1st Sess., Description of H.R. 3035, H.R. 1456, and H.R. 563, at 18 (Sept. 30, 1991). (41) Id., citing Treas. Reg. [sections] 1. 162-20(a)(2). (42) Joint Committee on Taxation, supra note 40, at 18. See also Knoxville Iron Co. v. Commissioner, 18 T.C.M. 251 (1959) (training costs held to be deductible when incurred); and Cleveland Electric Illuminating Co. v. Commissioner, 7 Cl. Ct. 220 (1985) (certain training costs were deductible when incurred; other training costs required to be capitalized because the costs related to the start-up of a new business). (43) Joint Committee on Taxation, supra note 40, at 18. (44) See Ithaca Industries v. Commissioner, 97 T.C. 253 (1991), aff'd, 17 F.3d 684 (4th Cir.), cert. denied, 115 S. Ct. 83 (1994). (45) 7 Cl. Ct. 220 (1985). (46) Treas. Reg. [sections] 1.174-2(a)-.1 (47) Id. (48) Treas. Reg. [sections] 1.174-2(a)-2 (emphasis added). (49) Treas. Reg. [sections] 1.263A-1(e)(4)(ii). (50) Commissioner v. Idaho Power, 418 U.S. 1 (1974). See also Treas. Reg. [sections] 1.266-1(e). (51) PLR 9426004 (Mar. 22, 1994). (52) PLR 9426004 (citing Temp. Reg. [sections] 1.263A-1T(b)(2)(v)(c)). (53) One example of such standards is the ISO 9000 series standards prescribed by the International Organization for Standardization. (54) Occasionally, the certification standards relate, not to how well a product is made or how reliable it is, but rather to how quickly it is made or may be shipped (to meet a customer's just-in-time inventory requirements), or how readily adaptable and multifunctional a process is. For service providers, the standards relate to issues of speed, accuracy, and flexibility in place or manner of performance of the services; for raw material suppliers, the standards may relate to issues of purity, resilience, or durability. (55) Cleveland Allerton Hotel, Inc. v. Commissioner, 166 F. 2d 805 (6th Cir. 1948); Cassatt v. Commissioner, 137 F. 2d 745 (3rd Cir. 1943); Rev. Rul. 69-511, 1969-2 C.B. 23. (56) See Rev. Rul. 95-32, 1995-16 I.R.B. 5. (57) 1994-2 C.B. 19. (58) See PLR 9527005 (Mar. 15, 1995). (59) PLR 9540003 (June 30, 1995). (60) See Woodward v. Commissioner, 397 U.S. 572, 577 (1970); United States v. Gilmore, 372 U.S. 39, 47 (1963). (61) Gilmore, 372 U.S. at 47. (62) McKeague v. United States, 12 Cl. Ct. 671 (1987), aff'd without opinion, 852 F. 2d 1294 Fed. Cir. 1988). (63) See Rev. Rul. 73-146, 1973-1 C.B. 61, as discussed in TAM 9540003. (64) See Rev. Rul. 70-392, 1970-2 C.B. 33. (65) See Rev. Rul. 79-208, 1979-2 C.B. 79. (66) See Cleveland Allerton Hotel, Inc. v. Commissioner, 166 F. 2d 805 (6th Cir. 1948); Cassatt v. Commissioner, 137 F. 2d 745 (3rd Cir. 1943); Rev. Rul. 69-511, 1969-2 C.B. 23. (67) See, e.g., PLR 9240005 June 12, 1992). (68) See, e.g., TJ Enterprises, Inc. v. Commissioner, 101 T.C. No. 39 (1993); PLR 9240005 (June 12, 1992). (69) Treas. Reg. [sections] 1.446-1(a)(4)(ii). (70) Treas. Reg. [sections] 1.461-1(a)(1). (71) Treas. Reg. [sections] 1.263(a)-l(a)(2)(b). (72) Section 167(a). (73) Lucas v. Ox Fibre Brush Co., 50 S. Ct. 273 (1930). (74) Kornhauser v. United States, 276 U.S. 145 (1928); Commissioner v. Tellier, 383 U.S. 687 (1966). (75) Treas. Reg. [sections] 1.162-21(b)(2). (76) Rev. Rul. 94-38, 1994-1 C.B. 38. (77) 7 Cl. Ct. 220 (1985). (78) As a matter of administrative convenience, employers with a large number of employees benefitting from the expenditure would likely prefer amortization in lieu of assigning such costs to employees and monitoring employee turnover to claim the proper education.
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|Date:||Mar 1, 1996|
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