Notice 96-7: request for comments on further capitalization guidance.

On March 20, 1996, Tax Executives Institute submitted the following comments to the Treasury Department and Internal Revenue Service in response to IRS Notice 96-7, which requested assistance in identifying approaches the government should consider to address the expense-versus-capitalization issue, particularly in light of the 1992 decision in INDOPCO v. United States. TEI urged the IRS and Treasury to promulgate general guidance on the important issue of whether certain expenditures may be currently deducted by taxpayers or, rather, must be capitalized. TEI's comments were prepared under the aegis of its Federal Tax Committee, whose chair is Bruce H. Barnett of Cargill, Inc. The following members contributed materially to the development of TEI's comments: Roger D. Wheeler of General Motors Corporation, Richard N. Kappler of MCI Incorporated, and the 1994-1995 chair of TEI's Federal Tax Committee, Michael A. Deluca of Household International, Inc. Also contributing to the development of the comments were Joseph Migas of MCI Incorporated and Margaret Satko and Neil Miller of General Motors Corporation.

Introduction

Proper matching of income and expense in order to clearly reflect income has been a source of contention between taxpayers and the government since the inception of the income tax. One recurring source of that friction is the requirement that proper distinctions be drawn between capital expenditures and deductible ordinary and necessary business expenses. The Supreme Court's decision in INDOPCO v. United States(1)(*) - which employed expansive, amorphous language to adjudicate a narrowly circumscribed set of facts - has sparked another cycle of controversy.

Indeed, despite frequent public assurances from the IRS National Office that "INDOPCO did not change the law regarding capitalization,"(2) agents have seized upon that decision's reference to "future benefits" to support novel capitalization theories. In many cases, agents have distended the Supreme Court's decision, casting aside well-settled law and practice supporting the deduction of many business expenditures. In some instances, agents have sought to undo methods of accounting approved by the National Office for a specific taxpayer. Regardless of the authority cited - whether sections 263 or 263A or, more baldly, INDOPCO - the same burdens are imposed on taxpayers: to produce reams of information replying to information document requests and to defend against unwarranted proposed adjustments.

Tax Executives Institute has monitored these developments and raised continuing concerns during annual liaison meetings with officials of the Department of the Treasury and Internal Revenue Service. In Notice 96-7,(3) the IRS invited public comment on the approaches it should consider to address issues raised under sections 162 and 263 particularly in light of INDOPCO. In response to that invitation, TEI submits the following analysis and list of issues that should be addressed to clarify that expenses incurred are generally deductible. Without guidance on these and other issues not addressed herein (for example, the need for further clarification of the scope of deductible environmental remediation expenditures), there will likely be protracted and continuing disputes between taxpayers and the government. We shall be pleased to discuss these issues in greater detail.

Background

Tax Executives Institute (TEI) is the principal association of business tax executives in North America. The Institute's approximately 5,000 members represent more than 2,700 of the largest companies in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and the government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works - one that is administrable and with which taxpayers can comply.

TEI members are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and training of our members enable us to bring an important, balanced, and practical perspective to the need for guidance on the deductibility or capitalization of expenditures in the aftermath of the INDOPCO decision.

Overview

1. The Need for

   General Guidance

   Since INDOPCO was decided, the IRS has issued several helpful rulings limiting or explaining the application of this decision to certain expenses. For example, in Rev. Rul. 92-80, the IRS held that advertising expenses are deductible notwithstanding the presence of some future effect on business activities.(4) The future benefit of advertising in nearly every instance is subsumed by the current benefit. In Rev. Rul. 94-12, the IRS held that incidental repairs continue to be deductible because INDOPCO did not "change the fundamental legal principles for determining whether a particular expenditure can be deducted."(5) Similarly in Rev. Rul. 94-38, the IRS held that soil remediation and groundwater treatment expenditures continue to be deductible.(6)

   Nonetheless, emboldened by INDOPCO, revenue agents continue to raise capitalization issues outside the narrow scope of that decision. If the IRS does not limit through advance guidance the scope of the application of INDOPCO, the number of cases in controversy will flood all levels of issue resolution (Examination, Appeals, and litigation). Resolving these controversies will consume a significant amount of time and resources for taxpayers, the IRS, and the courts and likely will be counterproductive to the IRS's goal of audit currency. Indeed, a recent GAO report summarizing data from the IRS's CENTAUR issue tracking system documents that capital expenditure issues accounted for 42 percent of the disputes in Appeals as of September 1994.(7 ) Those numbers are likely to increase, though, because of the continuing lag between examination cycles involving INDOPCO issues and their resolution, especially for large-case taxpayers.

2. Private Letter Ruling

   Process

   Notice 96-7 reminds taxpayers that they may obtain private letter rulings concerning the deductibility or capitalization of specific expenditures. The IRS requests comments on whether that process may be improved to facilitate advance resolution of these issues.

   TEI questions whether the IRS can or should modify the private ruling process in order to address capitalization issues separately from other forms of private rulings. The limitations of the private letter ruling process suggest that private rulings are no substitute for published guidance.

   The first limitation is the lack of precedential value of private letter rulings under section 6110(j)(3). This limitation protects the government from having taxpayer-favorable private rulings cited against its interest by anyone other than the affected taxpayer. On the other hand, taxpayer-adverse private rulings, while not strictly precedential, often achieve the same result as a published ruling since taxpayers must decide whether to comport themselves with the reasoning and result of the ruling, or - should the issue arise during the course of their own examination - challenge the ruling's analysis. Thus, the lack of precedential value in private rulings creates a perception (if not the reality) that the private ruling process is more calibrated in favor of the government than the public ruling process.

   The rationale for limiting the precedential value of private rulings is plain: the review process for private letter rulings is attenuated compared with that for published guidance. Specifically, private rulings are reviewed and approved at the level of the Branch Chief of the Chief Counsel's Office, while public rulings are often reviewed at the highest policy levels within the IRS and the Treasury Department. Hence, under Treas. Reg. [sections] 1.6662-4(d)(iii), published rulings are accorded greater weight for purposes of determining whether substantial authority exists to avoid the imposition of substantial understatement penalties. Moreover, published rulings are given greater deference by taxpayers - especially since the Appeals Branch of the IRS is bound by such rulings and taxpayers may be compelled to litigate to achieve a result at variance with a published ruling.

   The second limitation on the private letter ruling process is the diversion of resources - in terms of time and money - for both taxpayers and the government. Obtaining a private letter ruling generally requires months if not years, plus a significant commitment of taxpayer resources. As a result, taxpayers seek private letter rulings only (i) where a complex transaction is involved (and then only for those transactions for which consummation of the transaction may be deferred pending the receipt of a favorable ruling) or (ii) where the tax dollars at stake are significant but for which the timeliness of a ruling is not essential.

   Matters loosely referred to as INDOPCO issues, however, frequently involve expenditures for items that are not attributable to discrete transactions, are generally not segregated for financial accounting purposes, and are not deferred (or deferrable) until a ruling is obtained. Increasingly, INDOPCO issues derive from expenditures pertaining to normal, day-today operating expenses that have been challenged and reclassified by revenue agents as capital expenditures. Typically, such day-to-day operating expenses are reviewed for proper tax treatment only during the course of the taxpayer's return-preparation process. Given the time necessary to develop the facts, research the legal issues, draft the ruling request, respond to government...