On hearing about a “landmark” decision, practitioners expecting a dramatic development might have been disappointed to learn instead of a decision involving loan origination costs. Despite the mundane nature of the issue, the decision of the Third Circuit in PNC Bancorp Inc., 5/19/00, does indeed have the potential to be a “landmark.” If not reversed, this decision could represent an important turning point in the long-running controversy between taxpayers and the Service over item capitalization.

The Issue

PNC involved the proper treatment of loan origination costs. This term is shorthand for several different categories of costs that a bank incurs in connection with granting loans. These costs cover payments to third parties for credit reports, property reports and appraisals, and recording of security interests, as well as the salaries of bank employees involved in making loans. While banks traditionally deducted such expenses in the year incurred, two developments moved the Service to pursue capitalization of such costs.

SFAS No. 91 and INDOPCO

The first development, in time if not importance, occurred in 1986, when the Financial Accounting Standards Board (FASB) adopted Statement of Financial Accounting Standards (SFAS) No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating and Acquiring Loans and Initial Direct Costs of Leases,” effective for fiscal years beginning after Dec. 15, 1987. Briefly stated, SFAS No. 91 required banks to defer loan origination costs over the loans’ expected lives. However (as the Third Circuit observed), the original focus of SFAS No. 91 was not on the banks’ costs, but on its fees; the FASB was concerned that banks, as a result of charging high upfront fees, were overstating income in the initial years. Accordingly, SFAS No. 91 required banks to defer fees over the lives of the loans. It was at the urging of the banking industry that the FASB sanctioned the deferral of the associated costs. The industry argued that deferral of fees without deferral of the associated costs would distort the picture. Beginning in 1988, PNC deferred, for financial accounting and reporting purposes, the costs described in SFAS No. 91, while continuing to deduct them for tax purposes. The resulting difference between book and tax treatment was duly reported on PNC’s Schedule M-1.

The second development occurred in 1992 when the Supreme Court handed down its decision in INDOPCO, Inc., 503 US 79 (1992). Briefly (if narrowly) stated, INDOPCO required the capitalization of expenses incurred by a target corporation in connection with its friendly acquisition. The fallout from this decision has concerned its reach.

Tax Court

The key to the Tax Court’s decision in PNC, in favor of the IRS, was the Supreme Court’s decision in Lincoln Savings & Loan Association, 403 US 345 (1971), which set forth the “separate-and-distinct” asset test. The Tax Court noted that PNC did not deny that the loans in question were separate and distinct assets. Rather, it argued that “other factors” justified the deduction of the loan origination costs. Those “other factors” were arguments based on (1) the recurring nature of the expenses, (2) the fact that they were an integral part of the banking business and (3) their short-term benefit. The Tax Court did not find any of these factors sufficient to overcome the separate-and-distinct asset rationale of Lincoln Savings.

Third Circuit

The Third Circuit identified the issue as whether the loan origination costs qualified as “ordinary” business expenses under Sec. 162. Within the context of the banking business, the routine nature of these expenses was self-evident to the court, which then moved on to the question of whether the costs increased the value of property in such a way as to require capitalization under Sec. 263, as dictated by INDOPCO.

The Tax Court had considered Lincoln Savings controlling authority that required capitalization. Lincoln Savings involved the deductibility of premiums paid into a fund maintained by the Federal Savings and Loan Insurance Corporation (FSLIC). In Lincoln Savings, the costs in question were the separate-and-distinct asset (i.e., the premiums comprised the corpus of the fund maintained by FSLIC). The Third Circuit artfully distinguished Lincoln Savings by noting that the costs at issue in PNC were far from comprising the asset, the essence of the asset being the debtor’s promise to pay.

Next, the Third Circuit dealt with INDOPCO. Shifting ground from its holding in Lincoln Savings, the Supreme Court in INDOPCO stated that Lincoln Savings’ separate-and-distinct asset test was not the exclusive test for capitalization. Instead, in analyzing the deductibility of the target’s takeover-related costs, the Court adopted a “future benefit” analysis, and found that the target could reasonably have anticipated future benefits from the takeover. The Third Circuit did not distinguish INDOPCO, but rather found it consistent with its analysis in PNC. The Third Circuit, without much discussion, simply concluded that the costs in PNC had the “characteristics” of a Sec. 162(a) expense, rather than a Sec. 263(a) item.

Finally, the Third Circuit opinion dealt with SFAS No. 91, a matter of considerable importance to CPAs in the auditing field but, as most CPA tax practitioners know, nearly irrelevant to tax accounting. In arguing its case before the Third Circuit, the IRS “disavow(ed) any argument that the financial accounting standards should dictate tax treatment.” While acknowledging the Service’s concession, the Third Circuit appeared to criticize it for relying on SFAS No. 91 in “drawing the line” between capitalizing or expensing PNC’s loan origination costs. (The IRS could hardly have ignored the results dictated by SFAS No. 91, because PNC disclosed those results on its Schedule M-1.) In any event, the Third Circuit dismissed SFAS No. 91 as having “little, if any, bearing on the appropriate tax analysis.” Note: The disconnect between SFAS No. 91 and tax accounting was emphasized again this summer when the Court of Federal Claims decided in favor of the Service in American Express Co. (6/30/00). In accordance with SFAS No. 91, American Express had deferred, beginning in 1987, a ratable portion of its annual credit-card fees. Because this represented a change in its previous method of full inclusion in the year of receipt, the taxpayer sought IRS approval for the accounting change. The Service declined to grant approval; the taxpayer unsuccessfully sought a refund and later filed suit. The fact that SFAS No. 91 required deferral of a ratable portion of annual credit-card fees did not appear to have any bearing on the court’s decision. The court found that the IRS did not abuse its discretion in declining to approve the taxpayer’s request to switch to the accounting method prescribed by SFAS No. 91.

Conclusion

Several questions emerge from the PNC decision, not the least of which is the Service’s future plans. In many instances, the IRS would typically litigate similar issues in other circuits, in the hope of creating a conflict between circuits that would improve its chances for Supreme Court review. That course of action may not be readily available here, as the Eighth, Fourth and Tenth Circuits have handed down decisions that appear quite consistent with the Third Circuit’s PNC decision.

Beyond the IRS’s litigating strategy is its administrative role. It put the INDOPCO issue on the 2000 Priority Guidance Plan. As of this writing, the Service has not published any guidance. Given the IRS’s current preoccupation with corporate tax shelter abuses, one wonders when it will publish guidance in this area.

For taxpayers outside the banking industry, the impact of PNC is problematic. The question is how far the decision will reach. It is difficult to have much confidence in the “portability” of the PNC decision, when the Third Circuit uses phrases like “case-specific nature” and “case-by-case approach.”

From George L. White, CPA, J.D., AICPA Tax Division, Washington, DC