The need for additional guidance on capitalization issues.

On March 25, 1997, Tax Executives Institute submitted the following comments to the Internal Revenue Service concerning the need for additional guidance on the number of capitalization issues that have arisen in the aftermath of the Supreme Court's 1992 decision in INDOPCO, Inc. v. United States. The comments supplement a position paper that TEI filed with the IRS on March 20, 1996, in response to Notice 96-7, as well as a letter that was sent to Secretary of the Treasury Robert Rubin on November 6, 1996, concerning the treatment of asbestos remediation expenditures. TEI's comments were prepared under the aegis of its Federal Tax Committee, whose chair is David L. Klausman of Westinghouse Electric Corporation.

On behalf of Tax Executives Institute, I am pleased to respond to the invitation extended during the TEI-IRS liaison meeting to provide additional comments on capitalization issues that we believe warrant public guidance in the aftermath of the decision in INDOPCO, Inc. v. United States. This letter hence supplements the Institute's previous submission on March 20, 1996, in response to Notice 96-7, as well as a letter dated November 6, 1996, to Treasury Secretary Rubin urging the issuance of public guidance confirming the deductibility of asbestos remediation expenditures. The issues discussed at the liaison meeting include (i) the costs of recoding computer software to prevent potential errors arising at the turn of the century from the use of zeroes in two-digit fields representing the year in a date record (sometimes referred to as the year 2000' problem, the "century date" issue, or the "millennium bug"), (ii) limiting the broad scope of the "plan of rehabilitation" doctrine to preclude revenue agents from denying deductions for routine maintenance costs pursuant to a cyclical repair or removal policy, and (iii) routine costs incurred to expand or retain a business's customer base.

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our more than 5,000 members represent the 2,700 leading corporations 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 government alike.

General

In Notice 96-7,(1*) the IRS invited public comment on the approaches it should consider to address issues raised under sections 162 and 263 particularly in light of the Supreme Court's decision in INDOPCO.(2) In its March 1996 submission in response to Notice 96-7, the Institute identified a number of expenditures that warrant additional public guidance. Among the expenses that TEI identified in its submission were training costs - an area where revenue agents were creating unnecessary conflict and confusion by challenging expenditures that are generally deductible. Hence, we are pleased by the issuance of Rev. Rul. 96-62(3) and commend the IRS for confirming that, except in highly unusual cases, training costs remain deductible.(4)

Taxpayers are currently incurring expenses in many other areas that we believe warrant public guidance similar to that promulgated Rev. Rul. 96-62. These expenditures affect taxpayers in nearly every industry. We believe that the legal principles that taxpayers have analyzed -- and from which they have concluded that the identified business expenditures may be deducted -- can and should be restated in public guidance. Such guidance will afford taxpayers much greater certainty than the nebulous more than incidental future benefit" test set forth in INDOPCO -- a test that can all-too-easily be misapplied to capitalize routine, on-going, or recurring expenditures.

As a general principle of tax administration, taxpayers deserve guidance before they file their returns rather than several years later on examination. Moreover, by issuing public guidance earlier rather than later, scarce government and taxpayer resources that would otherwise be devoted to the resolution of these issues through examinations, appeals, private rulings, and litigation would be freed for other uses. Hence, in the interest of sound tax administration, the government should issue additional public guidance confirming the deductibility of the expenses set out below.

Year-2000 Expenditures

Description. The so-called year-2000 problem arises because many business application and system software programs employ two rather than four digits to specify the year in a date field.' In the past, programmers often used two digits to designate the year in order to save then-expensive computer processing and storage memory. Unless software and data files containing such date formats are remedied, computers with time-sensitive software programs and data files will, on January 1, 2000, likely treat the year "00" as though it were 1900. This in turn will lead the computer to make incorrect calculations, to perform illogical comparisons, or otherwise cause the computer to shut down -- "to crash."

Hence, year-2000 expenditures may be described as the costs incurred to identify and repair computer software code and data files in order to eliminate mathematical or logical errors that result from the use of zeroes in a two-digit data field representing the year for a particular date. The functional costs to identify and repair the code include salaries, payroll taxes, and benefits for employees; supplies; equipment depreciation; consulting fees; and other allocable overhead expenses. Year-2000 expenditures may also include the cost of replacing off-the-shelf software with an entirely new, year-2000 compliant version of the same software. Finally, taxpayers may also purchase specialized software tools to identify and remedy the coding defect.(6)

On a program-by-program (or file-by-file) basis, the expenditures to repair a program will often be de-minimis. Estimates vary, but one source projects that the cost of repairing software ranges from $0.90 to $1.50 per line of code.(7) The dependency of business taxpayers on so many different programs and files and the complex interrelationship among the various programs and data files, however, substantially increase the magnitude and scope of the year-2000 problem. Variations in programming styles and the potential for problems owing to the exchange of electronic or magnetic media between customers and their suppliers also increase the burden of remedying the year-2000 problem.

From an accounting perspective, the Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board (FASB) has declared that companies must expense costs incurred to fix the year-2000 problem. Under the EITF view, costs to remedy year-2000 problems are "incurred to keep the software updated and thus should be classified similar to repair and maintenance expenses."(8) Since the expenditures do not improve the software beyond the state in which it was intended to be used and do no more than restore it to its normal operating state, the EITF concluded that such costs -- being indistinguishable from other forms of repair and maintenance expenses -- are "period costs and should be expensed as incurred' rather than capitalized.(9) The EITF did not address the treatment of the purchase or licensing of a " year-2000 compliant" version of the same software to replace an existing version. Presumably, such costs will be accounted for under the taxpayer's normal policy for distinguishing between capital and period costs.

Analysis. Taxpayers are permitted deductions under section 162 for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. Although not defined in the Internal Revenue Code, courts have interpreted "ordinary" to mean any expenditure that is common and accepted in a particular industry or line of business.(10) The term "necessary" imposes only the minimal requirement that the expense be helpful or appropriate for the development of the...