The following article is adapted and reprinted from the M&A Tax Report, Vol. 11, No. 8, March 2003, Panel Publishers, New York, NY.
ANTI-INDOPCO REGULATIONS (PART TWO)
By Robert W. Wood
Last month, we covered an introduction to the proposed anti-INDOPCO regulations (see Wood, "INDOPCO: Dead Without a Wake?" Vol. 11, No. 7, The M&A Tax Report (Feb. 2003), p. 4. The proposed regulations, issued in the waning days of December 2002, cover a subject that is indisputably near and dear to every tax advisor's heart: deduction vs. capitalization. See REG-125638-01, 67 Fed. Reg. No. 244 (Dec. 19, 2002), p. 77701. In this article, we'll look at some of the aspects of the proposed anti-INDOPCO regulations that we weren't able to cover last time.
Transaction Costs Simplification
The devil is in the details, an old saw says. And, when it comes to the deduct vs. capitalize quandary, much of the recent discussion has concerned capitalization of various items that are related to the acquisition, creation or enhancement of an asset. Employee compensation and overhead costs, for example, have generated significant controversy. In the landmark case Commissioner v. Idaho Power Co., 418 U.S. 1 (1973), for example, the Supreme Court required capitalization of depreciation on equipment used to construct capital assets. The court there also noted that wages had to be capitalized if they were paid in connection with the construction or acquisition of a capital asset.
The more recent case of Lychuk v. Commissioner, 116 T.C. 374 (2001), required capitalization of employee compensation where the employees spent a significant portion of their time working on acquisitions of installment obligations. And, the IRS certainly likes to cite Revenue Ruling 73-580, 1973-2 C.B. 86, which required capitalization of employee compensation that is reasonably attributable to services performed in connection with mergers and acquisitions.
Of course, some courts have been mavericks, allowing deductions to float like a gentle breeze over the taxpayer, notwithstanding some connection to an acquisition or creation of an asset. In Wells Fargo v. Commissioner, 224 F.3d 874 (8th Cir. 2000), for example, a deduction was allowed for officers' salaries allocable to work performed during the negotiation of a merger, because the salaries originated from the employment relationship, not from the merger transaction. Then, PNC Bancorp v. Commissioner, 212 F.3d 822 (3d Cir. 2000), allowed a deduction for compensation and other costs of originating loans to borrowers. And even Lychuk v. Commissioner, 116 T.C. 374 (2001), cited above in the bad capitalize category, said that capitalization was not required for overhead costs allocable to the acquisition of installment loans. Reason? The overhead costs did not originate in the process of acquiring the installment notes, and would have been incurred even if the taxpayer did not engage in the acquisition.
So what do we do to resolve this inefficient case-by-case determination? The proposed regulations provide a simplifying assumption that employee compensation and overhead costs do not facilitate the acquisition, creation or enhancement of an intangible asset. Simple. This rule applies regardless of the percentage of the employee's time that is allocable to capital transactions.
De Minimus Costs
There is also a de minimus threshold, so that small transaction costs are simply not considered as facilitating a capital transaction. Therefore, they need not be capitalized. The de minimus threshold is set at $5,000. Note that if the cost in question is $5,001, the entire amount would be subject to capitalization (at least it has to be tested), whereas if that item had cost one dollar less, it would slip by under the de minimus exception.
As you might predict, the proposed regulations also contain rules for aggregating costs allocable to a transaction. Costs can't be unduly bifurcated to take advantage of the de minimus threshold. However, taxpayers can determine the applicability of the de minimus rules by computing the average transaction cost for a pool of similar transactions.
The Twelve Month Rule
One of the most important underlying concepts in the proposed regulations is the one year rule. Indeed, one of the hallmark capitalization concepts of the existing regulations is to look to whether an asset is created that has a useful life substantially beyond the close of the tax year. Looking at the useful life of the asset, some courts have adopted a one year rule. Under it, an expenditure can be deducted in the year it is incurred as long as the resulting benefit does not have a useful life that extends beyond one year. Simple.
The proposed regulations generally take this tack, saying that a twelve month rule will help reduce administrative and compliance costs. This "will it extend beyond one year" test has a number of qualifications and limitations. Notably, the twelve month rule does not apply to amounts paid to create or enhance financial interests, nor to amounts paid to create or enhance self-created amortizable Section 197 intangibles.
The twelve month rule also does not apply to contracts or other rights that have an indefinite duration. How does one determine the duration? Rights of indefinite duration include rights that have no period of duration fixed by agreement or law, or that are not based on a period of time, but rather are based on a right to provide (or receive) a fixed amount of goods or services.
Rights that are renewable receive special treatment in the proposed regulations, again, all for purposes of assessing the applicability of the one-year rule. Rules are provided for determining whether renewable periods should be taken into account in determining the treatment of a renewable contract within an initial term that falls within the scope of the twelve month rule. Basically, renewal periods are taken into account if there is a "reasonable expectancy" of renewal, which is a pretty easy standard to meet (note it does not say "substantially certain"). Predictably, whether a reasonable expectancy of renewal exists will depend on all relevant facts and circumstances.
Safe Harbor Amortization
Another feature of the proposed regulations is a fifteen year safe harbor amortization for certain created or enhanced intangibles that don't have readily ascertainable useful lives. Of course, this fifteen year period is consistent with the amortization period prescribed by Section 197. This safe harbor amortization does not apply to intangibles that are acquired from another party, nor does it apply to created financial interests.
Conclusion and Effect
It will be some time before all of the kinks are worked out of the proposed anti-INDOPCO regulations (ok, I'll admit it, I love saying "anti-INDOPCO" — too many years of hating INDOPCO I guess). Still, these proposed regulations — representing an enormous victory for the INDOPCO Coalition — represent an enormous step forward in resolving what has become one of the most nettlesome issues facing corporate tax practitioners today.
These proposed regulations will become effective only when they are published as final regulations, and we all know that may take years. Still, there's likely to be some spillover effect with the Service that can hardly hurt. If these proposed regulations are any indication of what's to come, a rather large portion of the volume of capitalization disputes that taxpayers and the Service have to suffer through should be eliminated. That's good news for everybody.
Anti-INDOPCO Regulations (Part Two), Vol. 11, No. 8, The M&A Tax Report (March 2003), p. 6.