Capitalization of Intangibles

In January, the Treasury and the IRS released an Advanced Notice of Proposed Rulemaking (ANPRM), providing the framework for comprehensive proposed regulations they intend to issue on the deductibility and capitalization of expenditures incurred in acquiring, creating or enhancing intangible assets. The ANPRM's purpose is to reduce disputes on capitalization issues related to intangible assets. It does not address the treatment of costs related to tangible assets (such as repair costs).

Treasury and IRS Concessions

In the ANPRM, Treasury and the IRS conceded three critical issues:

• The government accepted the "one-year rule" adopted by the Seventh Circuit in U.S. Freightways, 270 F3d 1137 (7th Cir. 2001), for certain prepaid expenditures (such as insurance).
• The forthcoming guidance is expected to reverse the long-standing position that internal compensation costs incurred in connection with a transaction must be capitalized (as stated in Rev. Rul. 73-580). Rather, such costs (other than bonuses and commissions related to the transaction) would be deductible currently; this result would be consistent with the holdings in PNC Bancorp, 212 F3d 822 (3rd Cir. 2000), and Wells Fargo, 224 F3d 874 (8th Cir. 2000).
• Expenditures incurred in connection with intangible assets, rights or benefits not specifically identified in the advance notice are presumed to be deductible currently, contrary to the position in INDOPCO, Inc., 503 US 79 (1992). According to the notice, only in "rare and unusual circumstances" would such costs have to be capitalized.

The presumption that expenditures that the advance notice does not identify or discuss would be deductible may necessitate reviewing prior Service guidance, with the possibility of revoking or modifying any existing guidance to the contrary. Such guidance could include Rev. Rul. 89-23, which addressed the tax accounting treatment of package design costs. It is anticipated that the proposed regulations will not only specify the types of expenditures that would be capital, but will also include examples of deductible expenditures to illustrate the operation of this presumption.

Treatment of Other Costs

Under the forthcoming guidance, taxpayers must capitalize amounts paid as consideration to purchase, originate or otherwise acquire a security, option or other financial interest described in Sec. 197(e)(1), as well as any debt. Also, amounts paid to another person to acquire intangible property (such as a customer base from that person) would also be capitalized.

Subject to the 12-month rule, capitalization would generally be required for:

• Prepaid items to include amounts paid for goods, services or other benefits;
• Certain market-entry payments to include amounts paid to an organization to obtain or renew a membership or privilege;
• Amounts paid to a governmental agency for a trade name, trademark, copyright, license, permit or other right granted by the agency;
• Amounts paid to enter into, renew or renegotiate an agreement that produces contract rights enforceable by the taxpayer (such as lease contracts);
• Payments made to terminate certain contracts (such as those by a lessor) or to induce a lessee to terminate a lease of real or tangible personal property, or by a taxpayer to terminate a contract that grants another person the exclusive right to conduct business in a defined geographic area;
• Amounts paid to facilitate the acquisition, production or installation of tangible property owned by another if the taxpayer receives an intangible future benefit; and
• Amounts paid to defend or perfect title to intangible interests (such as amounts paid to relinquish a claim to a particular trademark).

The ANPRM provides that capitalization would not be required for payments made by a lessee to a lessor simply terminating a lease, when no new agreement is made between the parties. Nor would capitalization be required for payments that merely create an expectation of a continued business relationship with another taxpayer, but do not create enforceable contract rights. Further, capitalization would not be required for ISO 9000 certification or similar costs.

For transaction costs, the notice generally would require capitalization of costs to facilitate the acquisition, creation or enhancement of intangible assets or benefits, as well as costs that facilitate the acquisition, creation, restructuring or reorganization of a business entity, a Sec. 1060(c) asset acquisition or the acquisition of capital. However, capitalization would not be required for employee compensation (except for bonuses and commissions paid in the transaction), fixed overhead or costs that do not exceed a specified dollar amount (such as $5,000). The anticipated guidance would not require capitalization of post-acquisition-integration costs or employee severance payments resulting from an acquisition, as these expenditures do not facilitate the transaction.

IRS Guidance on the ANPRM

On Feb. 26, the Large and Mid-Size Business (LMSB) and Small Business/ Self-Employed (SBSE) divisions released an internal memorandum advising IRS employees in Examinations about current positions on capitalizing intangibles. According to this memorandum, the ANPRM guidelines do not reflect current Service positions and do not give agents authority to concede these issues. Further, the treatment of transaction costs remains unchanged, and taxpayers should capitalize post-acquisition integration costs that produce substantial future benefits.

The positions stated in the memorandum appeared to be in conflict with the ANPRM's stated objective, which is to reduce IRS-taxpayer controversies. The only concession in the memorandum is acceptance of the one-year rule.

To clarify further the impact of the notice on current field activities, the Service announced in a chief counsel notice (CCN-2002-021) dated March 15, 2002, a change in its litigation position on capitalizing intangibles. The CCN states that until Treasury and the IRS finalize capitalization guidance, the Service will not assert capitalization for employee compensation (other than bonuses or commissions paid with respect to a transaction), fixed overhead or de minimis costs (i.e., not in excess of $5,000 per transaction) related to the acquisition, creation or enhancement of intangible assets. The CCN recognizes that there is substantial controversy and uncertainty as to whether a particular cost is sufficiently related to the acquisition, creation or enhancement of an intangible asset or a benefit to require capitalization. It notes that recent court decisions addressing this issue are difficult to reconcile, especially when the costs in question are fixed. Also, the CCN states that it is an inefficient use of resources to litigate certain transaction costs when they may be deducted under the forthcoming proposed regulations. Therefore, from a litigation perspective, pending further guidance, the notice provides that the IRS will no longer assert capitalization of employee compensation (other than bonuses and commissions, paid with respect to a transaction), fixed overhead and de minimis costs, for the acquisition, creation or enhancement of intangible assets.

In response to the positions stated in the CCN, the LMSB and SBSE divisions issued a subsequent internal memorandum on April 26, 2002, stating that based on tax administration considerations, the IRS has concluded that examination resources would be better used on other high-risk compliance issues, rather than requiring capitalization of employee compensation (other than bonuses and commissions paid with respect to a transaction), fixed overhead and de minimis costs (not in excess of $5,000 per transaction) related to the acquisition, creation or enhancement of intangible assets. Thus, exam agents should not propose Sec. 263(a) capitalization of such costs.

In view of the ANPRM and subsequent internal memoranda suggesting confusion over the advance notice's impact on current examination and litigation efforts, issues related to the capitalization of intangibles may continue to be a source of controversy and uncertainty, at least until the Service and Treasury issue definitive guidance.

From Kristin Hahn, M.S., Washington, DC