Retention of the Separate and Distinct Asset Test in the Final Intangible Asset Regs.

The Supreme Courts decision in INDOPCO, Inc. 503 US 79 (1992)denying deductions for banking and legal fees incurred to facilitate a friendly takeover offergave rise to concerns that the IRS would seek to curtail current deductibility of other types of business expenses that could be viewed as creating more than an incidental future benefit. In INDOPCO, the Court stated that business expenses with benefits extending beyond the current year might have to be capitalized, even if the expenditure does not create a separate and distinct asset. Many practitioners read the Courts holding as establishing a new future benefit standard.

While Treasurys published position was that INDOPCO did not change the fundamental principles for determining whether a particular expenditure may be deducted or has to be capitalized, many types of business expenditures became subject to greater IRS scrutiny on the basis of the future benefit standard articulated in the INDOPCO decision. This, in turn, created great uncertainly as to self-created intangibles and regular and recurring business expenditures. Although various IRS rulings issued subsequent to INDOPCO sought to clarify that decisions scope, the IRS recognized, with the publication of Notice 96-7 (inviting the public to suggest standards for broader guidance on capitalization issues), that its piecemeal approach to issuing specific guidance was unlikely to reduce the controversy.

New Guidance

Late last year, the Service issued final regulations (TD 9107, 12/31/03), addressing capitalization of costs to acquire or create an intangible asset. By expressly defining the categories and types of costs subject to capitalization, these regulations are a significant step toward minimizing protracted disagreements between the IRS and taxpayers as to the parameters of INDOPCOs amorphous future benefit standard.

While reserving the right to identifyin future published guidanceamounts paid to create or enhance a future benefit that must be capitalized, the final regulations do not retain an open-ended future benefit standard. Rather, they are intended to strike an appropriate balance between the Codes capitalization provisions and taxpayers ability to comply, and the IRSs ability to administer the law. At the same time, they reflect a conscious IRS decision to minimize resource allocation in this area in favor of other current priorities (e.g., tax shelter compliance).

Definition

According to Regs. Sec. 1.263(a)-4(b)(1)(iii), the types of costs requiring capitalization include amounts paid to create or enhance a separate and distinct intangible asset, as defined by Regs. Sec. 1.263(a)-4(b)(3):

[A] property interest of ascertainable and measurable value in moneys worth that is subject to protection under applicable State, Federal or foreign law and the possession and control of which is intrinsically capable of being sold, transferred or pledged (ignoring any restrictions imposed on assignability) separate and apart from a trade or business.

Under Regs. Sec. 1.263(a)-4(b)(3)(i), the determination of whether a payment creates a separate and distinct intangible asset is made based on all of the facts and circumstances existing during the tax year in which payment is made.

Although, under Regs. Sec. 1.263(a)-4(b)(3)(ii)(v), certain costs (e.g., amounts paid to create a package design, computer software or an income stream from the performance of services under a contract; product launch costs; and stock lifting costs) are expressly excluded from the scope of the separate and distinct asset test, taxpayers and advisers must be mindful of the regulations retention of the test.

Judicial History

The separate and distinct asset test has a long and tortured history. In Lincoln Savings & Loan Assn., 403 US 345 (1971), the Supreme Court addressed the proper tax treatment of Lincoln Savings special insurance premium payments to the Federal Savings and Loan Insurance Corporation. In holding that such payments could not be deducted under Sec. 162(a) as an ordinary and necessary expense, the Court said:

[T]he presence of an ensuing benefit that may have some future aspect is not controlling; many expenses concededly deductible have prospective effect beyond the taxable year. What is important and controlling, we feel, is that thepayment serves to create or enhance for Lincoln what is essentially a separate and distinct additional asset and that, as an inevitable consequence, the payment is capital in nature and not an expense, let alone an ordinary expense, deductible under section 162(a).

Subsequently, several circuit court decisions interpreted that case to mean that the Supreme Court had adopted a new test for determining whether an expenditure was deductible currently or required capitalization (see, e.g., Central Texas Savings & Loan Assoc., 731 F2d 1181 (5th Cir. 1984); The Colorado Springs National Bank, 505 F2d 1185 (10th Cir. 1974); and Briarcliff Candy Corp., 475 F2d 775 (2d Cir. 1973)). This new test permitted necessary business expenditures to be deductible fully during the tax year, unless they created or enhanced a separate and distinct additional asset; see Wells Fargo & Co., 224 F3d 874, 881 (8th Cir. 2000). For example, in Briarcliff, the IRS argued that costs to expand a business into new markets were capital. The Second Circuit rejected this, relying largely on the lack of a separate and distinct asset, as it interpreted Lincoln Savings & Loan to require. In INDOPCO, the Supreme Court disavowed the separate and distinct asset test as the exclusive means to distinguish between de-ductible and capital expenditures.

Summary

Although the final regulations are very helpful in restricting the future benefit standard, taxpayers and advisers must be mindful of the retention of the separate and distinct asset test. It remains to be seen how the definition articulated therein will be interpreted by the IRS on a prospective basis.

From Frederick Gordon, J.D., LL.M., Washington, DC