Transaction costs relating to acquisition or enhancement of intangible property: a populist, political, but practical perspective

Virginia Tax Review, Fall, 2002 by John W. Lee

"An outstanding feature of this criterion [of Practicality] is the restraint it imposes on zealous aspirations to achieve near perfect conformity with other criteria. Compromises, often quite crude, are forced frequently because dogged Practicality must be heeded." (1)

I. INTRODUCTION

Since the early 1970s, a taxpayer has been required to capitalize 2 costs of, and transaction costs incurred in connection with, the acquisition of a separate tangible asset under the origin of the claim doctrine of Woodward v. Commissioner (3) and United States v. Hilton Hotels Corp. (4) These cases stand for the proposition that mismatching the character of a claimed ordinary deduction when the related income is tax preferenced by either capital gains treatment or complete nonrecognition distorts the taxpayer's income. Moreover, such mismatching would violate section 446 of the Internal Revenue Code (Code), which requires that a taxpayer's method of tax accounting (which may include the tax treatment of an item's cost as a capital expenditure or a current expense) must clearly reflect the taxpayer's income. (5) In Commissioner v. Idaho Power, (6) Justice Blackmun extended the capitalization requirement to inside transaction costs of creating a tangible with substantial future benefits in order to prevent (1 ) a timing of income mismatch in violation of section 446(b), and (2) a violation of the judicial rule of tax parity under which inside and outside transaction costs should be treated the same. For example, the capitalization requirement would avoid providing a tax advantage to inside costs over identical outside costs of constructing or acquiring a tangible asset with future benefits. (7) Capitalization of transaction costs as to an intangible asset usually yields a far less elegant result, since the intangible asset can be depreciated only under section 167 and only if its useful life can be determined with certainty. (8) Taxpayers are seldom able to determine the useful life of an intangible asset, particularly with respect to business expansion and start-up costs. (9) To avoid the distortion of income of capitalization of such costs without depreciation, many, but not all, judicial and administrative authorities from the early 1970s through 1992 allowed a current deduction for expenditures yielding curren t and future intangible benefits. These expenditures included recurring business expansion costs, based on the erroneous reasoning that such costs were deductible if they did not create a separate asset (10). This line of reasoning was, in turn, based on a misreading of Commissioner v. Lincoln Savings and Loan Ass'n. (11) Underneath this mistaken no separate asset doctrine, however, lay factual patterns which would have supported application of one or another of the rough justice current deduction factors discussed in Part IV of this article.

The Supreme Court granted certiorari in National Starch and Chemical Corp. v. Commissioner (12) to resolve the conflict between the two lines of cases. Justice Blackmun, the author of Lincoln Savings and Idaho Power, explained in INDOPCO, Inc. v. Commissioner (13) that Lincoln Savings merely held that the cost of creating or enhancing a separate asset usually had to be capitalized -- not that the absence of such a tangible asset precluded capitalization notwithstanding more than incidental future benefits. (14) In this sense, future benefits were a strong, but not irrefutable; indicator of a capital expenditure.

Part II recounts how, over the last decade, expensing versus capitalizing of costs with present and future, often intangible benefits became the most significant federal income tax issue in audits of big businesses, which report the bulk of both the corporate sector income and additional tax revenues raised by tax audits and collections. (15) An indicator of this phenomenon was the action of the Internal Revenue Service (Service) in directing team tax auditors of the largest 1500 or so corporations (16) in the aftermath of IND OPCO to examine specific expensing/capitalizing issues, particularly those with future benefits flavor. This practice generated a flood of Technical Advice Memoranda (TAM) which often manifested conflicts between the Examination Division of the Service and the Office of Chief Counsel. In addition, this trend produced a few digest, published revenue rulings; (17) and a stream of reported judicial decisions that are impossible to reconcile. (18)

Between 25% and 40% of the audit and litigation resources of the Large and Mid-Size Business unit (LMSB) of the Service are devoted to INDOPCO issues. (19) After a wave of initial Service victories in the Tax Court, circuit courts are beginning to reverse these decisions, particularly where everyday or nondepreciable expenditures are at issue. (20) At the same time, corporate audit rates have rapidly declined over the past five years, (21) and widespread abuse of corporate tax shelters has occurred in the pool of the largest businesses in LMSB. (22) The media and others have drawn a connection between the decline in corporate audit rates and the use of corporate tax shelters, (23) which are viewed by many in the Treasury Department as the biggest tax problem at this time. (24)