P (1998), held that a banks costs of originating now cover the - PDF document

C C O O R R P P O O R R A T A T E E B B U U S S I N I N E E S S S S T T A A X X A T A T I O I O N N M M O O N N T T H H L Y L Y Tax Accounting BY JAMES E. SALLES BANK’S LOAN ORIGINATION the capitalizable cost of self-constructed improvements to the taxpayer’s plant included overhead such as COSTS EMERGE AS A HIGH- depreciation on the taxpayer-owned equipment that PROFILE ISSUE was used in the project. The uniform capitalization rules NC Bancorp, Inc. v. Commissioner , 110 T .C. 349 (Code Section 263A and accompanying regulations) P (1998), held that a bank’s costs of originating now cover the capitalization of expenditures in connec- loans had to be capitalized and amortized over tion with self-constructed tangible property, but intangi- the estimated lifetime of the loans. The decision remains ble property continues to be governed by Idaho Power on appeal. The outcome may mark a significant step in and its progeny to the extent its principles can be the evolution of the IRS’s and the T ax Court’s approach applied. to capitalization issues. The “Recurring Business Expense” Doctrine T wo months ago, this column examined the continu- In analyzing PNC , it is important to realize that, ing fallout from INDOPCO v. United States , 503 U.S. 79 notwithstanding INDOPCO, some expenditures with (1992), specifically Norwest Corporation v. consequences outside the taxable year remain current- Commissioner , 112 T .C. No. 9 (1999). Norwest held that ly deductible. For example, the T reasury regulations indirect costs, including investigatory costs and a por- expressly provide that selling expenses are currently tion of the target company’s officers’ regular salaries, deductible, 2 even though these in a sense relate to had to be included in the amount capitalized in connec- inventory property and may be incurred before the tion with a corporate acquisition. The direct holding of goods are removed from inventory and the associated INDOPCO was confined to a rejection of some courts’ cost of goods sold recognized as an offset to receipts. holdings that the government had to be able to point to a “separate and distinct asset” to require capitalization Since INDOPCO , the IRS has issued revenue rulings of an expenditure. The Supreme Court reaffirmed the providing that in normal circumstances, advertising expenses, 3 incidental repairs, 4 and employee training regulatory standard that an expenditure must be capi- talized if it produces a benefit “extending substantially costs 5 remain currently deductible, although considered beyond the taxable year.” 1 INDOPCO prompted the IRS in isolation they might have impact beyond the year of and the courts to revisit capitalization principles. expenditure. In the case of advertising expenditures, INDOPCO encouraged the IRS to be more aggressive this reasoning has received Congressional imprimatur in both in requiring different types of expenditures to be the legislative history accompanying the enactment of capitalized as free-standing “assets” and in requiring Code Section 197 in 1993. 6 The theoretical underpin- expenditures indirectly associated with intangible assets ning behind this sensible approach appears to be a to be capitalized into basis. “rule of reason”: Expenditures that regularly recur in the PNC Bancorp, Inc. v. Commissioner held that a bank’s course of the taxpayer’s trade or business should be costs of originating loans had to be capitalized and deductible because the overall result will be a clear amortized over the estimated lifetime of the loans. The reflection of income. Capitalization, after all, is ultimate- key Supreme Court cases are, again, INDOPCO and, in ly a reflection of the principle that income should be a supporting role, Commissioner v. Idaho Power Co. , matched with associated expenses. See, e.g., Comm’r 418 U.S. 1 (1974). The court in Idaho Power held that v. Idaho Power Co., 418 U.S. 1, 16 (1974). In Hillsboro National Bank v. Commissioner , 460 U.S. 370, 384 (1983), the Supreme Court itself implied James E. Salles is a member of Caplin & Drysdale, approval of the holding in Zaninovich v. Commissioner , Chartered, in Washington, D.C. D E C E M B E R 1 9 9 9 1

C C C C C C O O O O O O R R R R R R P P P P P P O O O O O O R R R R R R A T A T A T A T A T A T E E E E E E B B B B B B U U U U U U S S S S S S I N I N I N I N I N I N E E E E E E S S S S S S S S S S S S T T T T T T A A A A A A X X X X X X A T A T A T A T A T A T I O I O I O I O I O I O N N N N N N M M M M M M O O O O O O N N N N N N T T T T T T H H H H H H L Y L Y L Y L Y L Y L Y 616 F .2d 429 (9th Cir. 1980), that prepayments of recur- ly, the T ax Court did not hold that INDOPCO had changed the law. Instead, PNC held the facts of PNC ring period costs extending less than 12 months distinguishable because in the credit card cases the beyond the taxable year may be deducted currently, at courts had held the expenditures were not capitalizable least by cash-basis taxpayers. The primacy of “clear because they did not create a “property interest” and reflection” has been recognized by the courts both were not associated with a “separate and distinct before and after INDOPCO . See, e.g., Moss v. Comm’r, asset.” In contrast, the bank loans in PNC were sepa- 831 F .2d 833 (9th Cir. 1987), in which a hotel’s ongoing rate and distinct assets, as the taxpayer conceded. The remodeling expenses were deductible even though a court observed that “expenditures which otherwise particular unit might only be remodeled every three to might qualify as currently deductible must be capital- five years; cf. Cox v. Comm’r, 64 T .C.M. (CCH) 1123, ized if they are incurred in the acquisition of a separate 1126 (1992), in which there was no demonstration that and distinct asset regardless of their recurring nature,” asserted maintenance expenses did not have a “more 110 T .C. at 367, and concluded that PNC had to capi- than incidental” future benefit under INDOPCO or that a talize its loan acquisition costs. current deduction would otherwise clearly reflect PNC represents the T ax Court’s acknowledgment that income. recurring routine expenses are ordinarily deductible, PNC Bancorp even if these expenditures provide some future benefit. As in Norwest , the taxpayer’s problems in PNC start- On the other hand, PNC demonstrates that this rule ed when an accounting method change to conform to does not apply in connection with the acquisition of a financial accounting standards provided the IRS with a separate and distinct asset, such as a bank loan. PNC handy road map to an adjustment. Before 1988, PNC resurrects the pre- INDOPCO notion of a separate and recognized current income from origination fees distinct asset, albeit in another context. Rather than received at the inception of a loan, and likewise cur- holding that there is no capitalization if there is no sep- rently deducted the associated expenses. Starting in arate and distinct asset, the court held that there must 1988, PNC changed its method of accounting for finan- be capitalization if there is a separate and distinct asset. cial statement purposes to comply with SFAS 91. SFAS This conclusion would seem in keeping with the 91 required that PNC take the fees into income ratably Supreme Court’s holding in INDOPCO . over the lifetime of the loan, and required that the asso- If the T ax Court’s holding on this “separate and dis- ciated expenses—principally a portion of the payroll tinct asset” point is good law, which it probably is, the cost of personnel engaged in marketing loans—be seg- contours of the post- INDOPCO capitalization analysis regated and amortized. In practice, the net amount was are becoming clear. When confronted with whether a amortized into income over the lifetime of the loan. The taxpayer has a potentially capitalizable expenditure, the result was a Schedule M item too tempting for the IRS first inquiry should be whether the expenditure relates to to ignore. the creation or acquisition of a separate and distinct Both the IRS and the taxpayer recognized that the asset, a concept whose outer bounds are vague but receipt of up-front loan fees created immediate income that is probably coterminous with a separately salable under Schlude v. Commissioner , 372 U.S. 128 (1963), property interest. See 110 T .C. at 366. If there is no sep- and allied authorities. The controversy in PNC con- arate and distinct asset, however, the taxpayer is not cerned whether expenses associated with the receipt of home free. The next step is to examine whether the front-end revenue could be immediately deducted or expenditure provides a “more than incidental” benefit had to be included in the loans’ basis. that extends “substantially” beyond the taxable year. The taxpayer argued that “everyday, recurring” busi- Capitalization is often required under INDOPCO . An ness expenses did not have to be capitalized, relying expenditure may be deducted, notwithstanding some on a series of cases in the 1970s that so held as to future benefit, if the taxpayer can establish that the banks’ expenses (for credit investigations and the like) result clearly reflects income and the expenditure is a incurred in setting up credit card accounts. These routine business cost that is being incurred relatively credit card cases antedated INDOPCO , but significant- evenly over time. The expenditure can represent repairs 2 D E C E M B E R 1 9 9 9