CBTM 4-10 July issue 6/25/03 10:34 AM Page 13 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 This month’s column continues the discus- approach under which most indirect costs that had some relation to productive activity had to sion of the treatment of taxpayers’ internal costs (employee compensation and “over- be capitalized. Several cases approved the head”) in the proposed “ INDOPCO regula- IRS’s imposing this treatment when the tax- payer had capitalized no overhead at all, 7 but tions.” The May issue described the “incremen- these seem to have reflected the principle that tal costing” approach that prevailed before the the IRS gets to choose among acceptable meth- advent of detailed rules governing manufac- ods if the taxpayer’s method is wrong. 8 The turing and construction. The following discus- courts suggested that only costs that varied sion begins with a summary of the authorities with production (“variable costs”) had to be addressing intangible property, and then turns capitalized, while the treatment of “invariable” to the proposed regulations. costs, such as rent and real estate taxes, was optional. 9 Similarly, employees’ compensation Basic Principles was allocated when they spent substantial time on manufacturing and construction activities, 10 Background: Tangible Property but not when their involvement was sporadic Before detailed regulations were adopted in or “incidental.” 11 Something close to “full the 1970s, the courts and the IRS had largely absorption” costing was eventually imposed followed an “incremental cost” approach to by regulation and, eventually, in the uniform capitalizing manufacturing and construction capitalization (“UNICAP”) and contract cost- outlays. This method was sometimes referred ing rules enacted in the Tax Reform Act of to as “direct costing,” but that did not mean 1986. 12 None of these rules apply to intangible that only direct materials and direct labor had property except in very limited situations, to be capitalized. The courts consistently however, so the early cases remain the starting required capitalizing at least some indirect point for analysis. (“overhead”) costs. This was equally the case as to inventory, 1 where the regulations express- The “Directly Related”Standard ly so required; 2 long-term contracts, 3 where Intangibles costing questions generally arise they did not; 4 and self-constructed property, in one of two settings. The first type of situa- which was not specifically addressed in regula- tion involves intangibles acquired, created, or tions at all. 5 The Supreme Court held in entered into in the course of ordinary business Commissioner v. Idaho Power Co. 6 that all types operations. The question is whether recurring of costs are subject to capitalization unless outlays like salaries and different types of some specific exception applies. overhead are part of the cost of that class of There was more uncertainty about which intangibles. The second type of situation indirect costs had to be capitalized. The IRS involves an isolated, more or less one-of-a-kind favored a “full absorption” or “full costing” transaction like a business acquisition. The first issue in such cases is identifying the outlays that would not have been incurred “but for” the transaction and are closely enough related Jim Salles is a member of Caplin & Drysdale in to it to justify capitalization. The second ques- Washington, D.C. J U L Y 2 0 0 2 13
CBTM 4-10 July issue 6/25/03 10:34 AM Page 14 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 tion that arises is whether recurring costs A 1974 general counsel memorandum con- should be attributed to the transaction even if sidered a proposed revenue ruling addressing they would have been incurred anyway. financial institutions’ loan costs, destined to The relatively sparse early authorities car- become a recurring and troublesome issue. The ried over principles familiar from the manufac- National Office required that “directly related” turing and construction cases. Revenue Ruling expenditures—the example given was employ- 68-561 13 required a utility to capitalize subsidies ee commissions—be capitalized, again empha- of new customers’ gas appliances but allowed sizing that “in-house” costs and external costs deductions for salaries and advertising because should be treated the same. However, deduc- these were less “directly and significantly pro- tions were allowed for “salaries, rents, office ductive of intangible assets.” The National overhead, and other similar expenses,” even Office concluded that requiring capitalizing though the taxpayer maintained a dedicated these costs would conflict with the traditional staff “for the primary purpose of soliciting deductibility of marketing expenses, and it was mortgage loans.” This position was arguably hard to properly amortize them. 14 Presumably, more liberal than the construction and manu- the promotional program did not involve sub- facturing cases, which capitalized compensa- stantial incremental costs apart from the subsi- tion of employees predominantly engaged in dies. Revenue Ruling 69-331, 15 by contrast, con- “capital” activities. cluded that bonuses and commissions (both in- The IRS revisited the issue two years later, 21 house and external) were “directly related” to when it considered another proposed ruling, another utility’s leases of equipment to its cus- this one involving a mutual life insurance com- tomers and had to be amortized over the lease pany that invested in mortgage loans and real terms. Revenue Ruling 73-580 16 held employee property. The taxpayer maintained an “invest- compensation attributable to corporate mergers ment department,” including loan specialists, and acquisitions must be capitalized, emphasiz- lawyers, appraisers, and actuaries, working ing that “internal” expenses should be on the exclusively on acquisition-related matters. same footing as comparable outlays to out- Again emphasizing that in-house costs were siders. 17 The ruling did not discuss how the subject to capitalization, this time the National salaries were to be attributed, but both cases Office concluded that the salaries and “other that it relied upon were consistent with incre- expenditures” attributable to those employees mental costing. One involved a specially desig- were “directly related” to the investments. nated executive bonus, 18 and in the other, essen- tially all of the officers’ services related to a past Other Pre- INDOPCO Authority capital transaction. 19 Taken together, the rulings and internal Over time, the IRS came to focus on “recur- documents suggest that the IRS thought costs ring” capital transactions involving assets regu- should be assigned to intangible property larly created or acquired in ordinary business much as they were to real and tangible person- operations. The taxpayer in Revenue Ruling 74- al property before the “full absorption” regula- 104 20 regularly renovated real property for tions. The cost of assets derived from ordinary resale. The ruling concluded that both pay- operations would include labor and possibly ments to agents involved in acquiring the prop- variable overhead (likely small) attributable to erties and “salaries, travel, and other related the overall “capital activity,” even these could costs subsequently incurred by the taxpayer in not be identified to any individual asset pro- evaluating the agent’s report” were capital. The duced. “One of a kind” transactions would ruling did not, however, specify how the require capitalizing only outlays that would “salaries, travel, and other related costs” were otherwise not have been incurred, which to be identified. would exclude most internal costs, except 14 J U L Y 2 0 0 3
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