Treatment of capitalized costs of intangible assets: this two-part article examines cost recovery of intangible asset expenditures. Part I summarizes the applicable capitalization regulations, Sec. 197 cost recovery and general Sec. 167 amortization rules.

• Author: Witner, Larry
• Position: Part 1

EXECUTIVE SUMMARY

* Regulations issued in 2004 require capitalization of six categories of intangible asset expenditures.

* When Sec. 197 applies to intangible expenditures, 15-year amortization takes precedence over all other cost recovery rules.

* Intangible assets may be amortized under Sec. 167 when Sec. 197 does not apply and the asset has a limited useful life.

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In 2004, the Service issued final regulations (1) under Sec. 263(a) on capitalizing the cost of intangible assets. While much has been written about this topic, (2) not much has been written about the aftermath of capitalization--i.e., once the cost of an intangible asset has been capitalized, how is that cost recovered? This two-part article:

1. Summarizes the new Sec. 263(a) regulations (as discussed below, otherwise known as the "INDOPCO regulations");

2. Examines cost recovery possibilities, including, among other authority, Sec. 197 (amortizable Sec. 197 intangibles) and Sec. 167 (other intangibles); and

3. Examines how the INDOPCO regulations affect the treatment of certain startup costs under Sec. 195.

   Part I, below, summarizes the INDOPCO regulations, Sec. 197 cost recovery and general Sec. 167 amortization rules. Part II, in the May 2007 issue, will focus on the income-forecast method, lease acquisitions, options, computer software, and transaction and business acquisition costs.

   Background

   In general, expenditures are deducted currently (expensed), capitalized and deducted over time or capitalized with no deduction. Under Sec. 162(a), expenditures are deducted currently if they are ordinary and necessary business expenses. Under Regs. Sec. 1.263(a)-2(a), expenditures are capitalized if they result in benefits that extend substantially beyond the end of the tax year. Under Kegs. Sec. 1.263(a)-1(b), expenditures are capitalized if they result in permanent improvements or betterments, including materially increasing value, appreciably prolonging useful life or adapting an asset to a new or different use.

   In 1992, the Supreme Court held in INDOPCO (3) that expenditures should be capitalized if they result in significant future benefits, whether or not they produce a separate and distinct asset. Unfortunately, the significant-future-benefits test raised more questions than it answered.

   To clarify matters with regard to intangible assets, the IKS issued Regs. Sec. 1.263(a)-4 (acquiring or creating intangibles) and Regs. Sec. 1.263(a)-5 (facilitating the acquisition, restructuring or reorganization of a business). These regulations, commonly called the "INDOPCO regulations," are effective for intangible asset costs paid or incurred after 2003. They are intended to provide bright-line rules (4) to make the INDOPCO-standards-based approach (significant future benefits) for capitalization more administrable;

   INDOPCO Regs.

   The INDOPCO regulations (5) require capitalization of six categories (6) of expenditures relating to intangible assets; they are numbered and summarized in the exhibit on p. 214. Of these six categories, four pertain to direct costs and two pertain to indirect costs (otherwise known as "transaction costs"). In this article, reference is made, for example, to "category 1, 2, 3 or 4 intangible assets" and "category 5 or 6 transaction costs"

   Regs. Sec. 1.263(a)-4(b)(4) provides that the INDOPCO regulations do not affect the treatment of amounts specifically provided for in Code sections (and regulations thereunder) other than Sec. 162 (ordinary and necessary business expenses) or 212 (expenses of producing income). For instance, the INDOPCO regulations do not apply to research and development costs, because Sec. 174 specifically applies.

   If an expenditure does not fall into one of the six categories, or is not identified in subsequently published guidance, capitalizing is not required, and deducting is allowed. (7) In other words, under the INDOPCO regulations, listed categories of expenditures are to be capitalized; everything else is to be deducted. While this approach seems harmless, it reverses well-established principles. Before the INDOPCO regulations, capitalizing was the norm; deducting was the exception. After the INDOPCO regulations, at least with regard to intangible assets, deducting is the norm; capitalizing is the exception.

   Cost Recovery (Amortization) in General

   The INDOPCO regulations are capitalization provisions, not cost recovery provisions. For the latter, taxpayers should refer to:

   * Sec. 197 (15-year amortization);

   * Sec. 167, (8) in which the cost of an intangible asset is:

1. Amortized over the asset's useful life; (9)

2. Amortized over 15 years (safe harbor);

3. Not amortized; or

4. In some cases, amortized using the units-of-production method or the...