C O R P O R A T E B U S I N E S S T A X A T I O N M O N T H L Y Tax Accounting BY JAMES E. SALLES advertising expenses, 7 incidental repairs, 8 severance IRS WINS BEFORE THE TAX COURT payments, 9 and employee training costs. 10 IN NORWEST INDOPCO has encouraged a variety of litigation and recent IRS victory before the T ax Court in A other activity relating to various capitalization issues. Norwest Corporation v. Commissioner 1 flesh- Its first and most obvious implication relates to the es out the law concerning the capitalization issue of what is a capital asset. Most directly, the of expenditures in connection with corporate acquisi- INDOPCO holding has spawned a series of controver- tions. The case has broader implications as well, sies about unfriendly takeovers, and in what circum- since it follows INDOPCO v. Commissioner . 2 stances a target company does, and does not, realize a benefit “extending substantially beyond the taxable INDOPCO year.” 11 In INDOPCO , the U.S. Supreme Court clarified that its More broadly, INDOPCO has prompted the courts to rethink when exactly an “asset” with “value” is created earlier decision in Commissioner v. Lincoln Savings & Loan Association 3 did not require that an expenditure in the absence of an identifiable tangible or intangible “property”. Courts’ reliance on the “separate and dis- “create or enhance . . . a separate and distinct original tinct . . . asset” concept was never taken to logical asset” in order to be capital. INDOPCO required a tar- extremes. No one seriously argued, for example, that get company to capitalize expenditures associated with prepaid expenses were not capitalizable. As the a friendly acquisition. The INDOPCO Court stressed INDOPCO court pointed out, 12 the concept of an asset that the overriding goal of tax accounting was to reflect income clearly. 4 INDOPCO referred to the traditional is itself somewhat “flexible and amorphous”— but it pro- vided a handy hook on which courts so inclined could regulatory standard that requires capitalization when hang a conclusion that a debatable expenditure was “an expenditure results in the creation of an asset hav- not subject to current capitalization. INDOPCO has ing a useful life which extends substantially beyond the cast a shadow on such cases as Briarcliff Candy Corp. close of the taxable year” under T reasury Regulations v. Commissioner , 13 where the court relied in part on the Section 1.461-1(a)(1). “separate and distinct . . . asset” concept to hold a Post- INDOPCO courts frequently follow a two-step wholesaler’s marketing expenditures relating to an analysis, inquiring first whether there is a “separate and ongoing business currently deductible. distinct asset,” and if there is not, whether there is an asset with a useful life extending “substantially beyond” IDENTIFYING EXPENDITURES the taxable year. 5 The language of the opinion in ASSOCIATED WITH CAPITAL INDOPCO , particularly the Court’s observation about ASSETS deductions being “exceptions to the norm of capitaliza- tion,” 6 was sweeping. The IRS has repeatedly felt itself Self-developed assets, or acquired assets in which the constrained to issue revenue rulings to assure taxpay- taxpayer expends significant amounts in connection ers that it will not read INDOPCO to overturn 60 years of with the acquisition, present a further inquiry: Once an case law concerning such matters as deductions for asset has been determined to exist, what kinds of expenditures, incurred over what time period, are includible in its basis? These issues are not new, but James E. Salles is a member of Caplin & Drysdale, Chartered, in Washington, D.C. have a higher profile than in the past because they are O C T O B E R 1 9 9 9 1
C O R P O R A T E B U S I N E S S T A X A T I O N M O N T H L Y more likely to be troubling in connection with the more Norwest court held that the expenses had to be capi- amorphous assets that are likely to be identified in the talized because “[t]he disputed expenses are mostly wake of INDOPCO . Both were addressed by the T ax preparatory expenses that enabled [the target] to Court in Norwest . achieve the long-term benefit it desired from the trans- The IRS recently addressed the timeline issue in action, and the fact that the costs were incurred before Revenue Ruling 99-23, 14 a ruling under Code Section DBTC’s management formally decided to enter into the 195. Code Section 195 allows amortization of start-up transaction does not change the fact that all these costs expenditures that “if paid or incurred in connection with were sufficiently related to the transaction.” The target’s the operation of an existing active trade or business . . . benefit from the transaction, of course, created a capi- would be allowable as a deduction for the taxable year talizable asset under INDOPCO . Thus, the T ax Court in which paid or incurred.” The IRS, with support from clearly subscribes to the principle that there is no the courts, 15 reads this language as requiring an particular magic associated with the date on the INDOPCO analysis be performed first. If the expendi- paperwork. ture would pass muster as a current expense except for How far to reach in determining what kinds of expen- the absence of an ongoing trade or business, it is sub- ditures are attributable to an acquisition or other capital ject to amortization under Code Section 195. transaction has also been somewhat hazy. In Commissioner v. Idaho Power Co ., 16 the U.S. Supreme Otherwise, the expenditure must be capitalized, and is amortizable, if at all, under normal rules. Consequently, Court held that indirect costs, and specifically deprecia- the same principles apply as in the normal capitalization tion attributable to the use of the taxpayer’s equipment, context. had to be capitalized into the cost of improvements of Revenue Ruling 99-23 featured a series of fact pat- the taxpayer’s plant. The uniform capitalization rules terns involving costs incurred by a taxpayer in connec- now provide specific rules for self-constructed tangible tion with corporate acquisitions. The general principle property, but intangibles continue to be governed by is that investigatory costs are deductible (or, in the Idaho Power, to the extent its principles can be applied. Section 195 context, amortizable) and costs attributable The court in Norwest lined up on the side of the to a particular acquisition must be capitalized. The IRS Commissioner on a key point. Besides outside profes- chose to draw the line between investigatory costs and sional fees, the Commissioner also asserted that some costs deemed attributable to an acquisition at the $150,000 of the target company’s officers’ regular moment when the acquiring taxpayer makes a decision salaries should be capitalized as relating to services to focus its efforts on a particular target. Costs incurred performed in connection with the acquisition. The par- strictly to facilitate a potential acquisition are capital, ties stipulated that the officers were regular employees regardless of whether the identity of the target is known of the target and that they would have been paid exact- when they are incurred. Revenue Ruling 99-23 made ly the same if there had been no merger at all. the IRS’s view clear that it is the taxpayer’s decision, not Nonetheless, the court upheld the Commissioner in the manifestation of that decision (for example, the sign- requiring capitalization. Although the court did not ing of a letter of intent), that matters. specifically discuss the point, this is significant because This somewhat controversial attempt at formulating a it means that a direct cost or incremental approach to bright-line test has received a boost from the court’s determining the amount of expenses attributable to a analysis in Norwest . The taxpayer in Norwest , the sub- capital transaction is not acceptable. In the future, tax- ject of a friendly acquisition, sought to deduct investi- payers may face a revenue agent sifting through what gatory expenses incurred up until the day that the tar- they would consider ordinary operating expenses in get’s board approved the merger and negotiated a con- search of expenditures to attribute to contemporaneous ditional agreement. Amounts paid for services directly capital transactions. relating to the actual transaction, such as negotiating In Norwest , the executive salaries and other over- price, preparing the fairness opinion, and handling the head-type costs attributable to the acquisitions were necessary regulatory filings, were not at issue. conveniently laid out in the taxpayer’s financial Citing INDOPCO and the matching principle, the statements. Financial reporting has gotten taxpayers 2 2 O C T O B E R 1 9 9 9
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