by George G. Jones and Mark A. Luscombe
Final capitalization-of-intangibles regulations topped the list of new guidance that the Treasury Department recently pushed out in time for the start of tax season. Taxpayers can breath a deep sigh of relief on several important issues in these highly anticipated rules.
However, the final regs do force taxpayers to adopt new procedures if they wish to capitalize on certain aspects that have been liberalized since the release of the proposed regs in 2002.
What’s covered, what’s not
The final regs under Code Section 263 cover amounts paid to acquire or create an intangible. Amounts paid to acquire or create an intangible must be capitalized when involving:
• An acquired intangible (ownership in a corporation, partnership, LLC or other business entity, a debt or financial instrument, lease agreement, copyright, trademark or patent, or goodwill, customer list or other Code Section 179 intangible [computer software will be addressed in later regulations, as will the entire capitalization issue surrounding tangible assets]);
• A created intangible (including pre-paid expenses, paid to another party to create an intangible);
• A future benefit identified in published guidance as an intangible requiring capitalization; and,
• The facilitation of the acquisition or creation of an intangible.
In INDOPCO vs. Commr., 503 U.S. 79 (1992), the Supreme Court required capitalization of expenses that produced a “significant future benefit.” Before this Supreme Court decision, capitalization had been required only when expenses were paid or incurred to create, acquire or enhance separate and distinct assets.
INDOPCO created confusion over how the “significant future benefit” rule fit into the overall picture. The final regs, for the most part, end the confusion.
Instead of leaving it to the taxpayer to divine the intentions of the Supreme Court, the final regs simplify matters considerably. They provide the exclusive guidance for capitalization of intangibles. Amounts paid to acquire or create an intangible, not otherwise required to be capitalized under the regs, are not required to be capitalized simply because they produce a significant future benefit.
So, for example, amounts paid for business process re-engineering, although creating a long-term benefit of increased efficiency, are not considered otherwise spent to create or acquire an intangible.
One important caveat, however, was added to the final regs. If the Internal Revenue Service publishes guidance in either the Internal Revenue Bulletin or the Federal Register requiring capitalization of a particular expenditure, it must be capitalized — on a prospective basis — no matter what the argument. Of course, a taxpayer is free to litigate whether the IRS has made the correct decision with respect to a particular intangible earmarked for capitalization. The IRS, in turn, will be free to raise INDOPCO’s “significant future benefit” argument in any litigation.
In the recent past, when fears of the INDOPCO juggernaut were high, the IRS appeared to bend over backwards not to use the Supreme Court’s decision aggressively. For example, a fairly recent ruling permitted heavy-duty aircraft maintenance expenses to escape capitalization. Hopefully, future supplemental guidance from the IRS will continue this accommodation.
Enhancement of intangibles
The final regs not only narrow INDOPCO, they also drop the requirement that expenses enhancing intangibles must be capitalized for that reason alone. The requirement was presumably dropped from the final regs because of vagueness and concern about how the rule would be administered. For example, the cost of maintaining acquired goodwill might be misconstrued to require capitalization. The regs instead get more specific by requiring, for example, capitalization of membership upgrades.
In addition, the final regs specifically exempt certain expenses from capitalization that create separate and distinct assets. This list includes amounts paid for services under an agreement, amounts paid to develop computer software, and amounts paid to develop a package design.
More exceptions for transaction costs
Amounts paid to facilitate the acquisition or creation of an intangible asset must be capitalized. The regs clarify that capitalization is required if paid in the process of investigating or pursuing the transaction. Under the proposed regs, the question of whether the costs would have been incurred “but for” the transaction was not relevant. The final regs make the inquiry relevant, but not determinative. Instead, a more flexible “facts and circumstances” test applies.
The regs continue to provide that in-house overhead and employee compensation expenses, which might be allocable to a transaction, need not be capitalized. They expand compensation to include guaranteed payments to a partner, payments to a corporate director, payments within an affiliated group filing a consolidated return, and amounts paid to outside contractors for clerical and other administrative services.
When investigating business opportunities, careful notes should be kept and filed. Reasons relating to the ongoing business operations should be emphasized in efforts to classify expenditures as immediately deductible.
In addition to compensation and overhead, other amounts paid to investigate or pursue a transaction need not be capitalized if they do not exceed $5,000. This $5,000 limit is applied for each transaction, however, exclusive of compensation and overhead. It is an all-or-nothing rule.
However, once all eligible expenses are determined to be $5,000 or less, an election to capitalize may be made separately with respect to each expense. S corporations and partnerships make the election on an entity level. This election, for example, might be made to soak up expiring NOLs, or simply to keep financial accounting and tax records consistent.
Expenditures that create a short-term benefit not longer than 12 months may be deductible even though the period straddles two tax years. For example, a nine-month covenant not to compete need not be capitalized. However, accrual-basis taxpayers still must pass the economic performance test for the provision of goods and services before a deduction is allowed.
Exceptions to the ‘facilitate’ rule
Costs incurred to facilitate the acquisition of a trade or business must also be capitalized. Transactions include asset and equity acquisitions, restructurings and reorganizations, 351 or 721 transfers, debt or equity issuance, and writing options.
The final regs tighten the scope of what “facilitates” a transaction. Generally, the definition mirrors the language in the transaction cost rule, including the investigatory and “but for” analysis. These regs, however, carve out several noteworthy exceptions:
• Costs incurred to dispose of assets not wanted by the acquiring corporation are not required to be capitalized, even if incurred to actually facilitate the merger;
• Amounts paid to investigate or pursue stock distributions mandated by law (for example, divestitures) need not be capitalized;
• Any portion of a bankruptcy proceeding that relates to the resolution of certain tort liabilities may be expensed; and,
• Amounts paid to integrate business operations with the operations of another business do not facilitate a transaction and need not be capitalized.
Bright-line standard for ‘facilitating’ a transaction
The final regs provide a bright-line test for determining the point at which an expense may be deemed to facilitate the transaction. The point beyond which capitalization is required does not require a binding agreement.
However, an amount is not deemed to facilitate a transaction until it is incurred upon the earlier of the date on which a letter of intent, exclusivity agreement or similar agreement is executed by the parties, or the date on which all material terms of the transaction have been agreed to by the governing officials of the taxpayers.
To prevent delay on a transaction to avoid the capitalization requirements, the regs provide that expenses inherently facilitative of a transaction must be capitalized irrespective of timing.
These expenses include appraisals, fairness opinions, tax structuring advice, obtaining regulatory approval, obtaining shareholder approval, drafting the purchase agreements and conveying property. Nevertheless, maneuvering through delay seems inevitable in planning to avoid the capitalization of other, related costs.
As with in-house costs related to business acquisitions, employee compensation, overhead and the de minimis expense rules — even if they might otherwise be deemed to “facilitate” a transaction — are to be expensed, not capitalized, unless the taxpayer elects otherwise.
No ‘clear reflection of income’ fallback
There seemed to be a period of litigation in the 1990s in which the IRS pulled the “clear reflection of income” requirement under Code Section 446(b) out of its hat whenever it was losing on another argument. The IRS states that it will not do this here.
If an amount paid to acquire or create an intangible is not required to be capitalized by another code provision (e.g., 174) or by the final regs or in subsequent published guidance, the IRS promises not to raise section 446(b) as necessitating capitalization.
The Treasury Department and the IRS clearly have recognized the confusion that has reigned since the INDOPCO decision in 1992 over what expenses must be capitalized.
The final regs allow taxpayers more certainty in predicting results. Whether they are sufficiently liberal will continue to be open to debate. There is no guarantee that the IRS will not revert to a more hard-line interpretation of INDOPCO in applying its “future benefit” principle to specific expenses to be addressed in future published guidance.
For the time being, however, working with the new regulations requires a detailed knowledge of them, in order to construct the most convincing documentation possible to avoid or minimize capitalization.
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