Comments on ANPR on capitalization: April 24, 2002.

On April 24, 2002, Tax Executives Institute filed comments with the U.S. Treasury Department and Internal Revenue Service in response to a request in an Advance Notice of Proposed Rulemaking, Announcement 2002-9, relating to guidance addressing the capitalization of expenditures that create or enhance intangible assets or benefits. The forthcoming proposed rules are intended to provide greater certainty in respect of the treatment of such expenditures and to reduce the scope and number of capitalization controversies that have arisen since the decision in INDOPCO v. United States. The comments were prepared by TEI's Federal Tax Committee, whose chair is Mitchell S. Trager of Georgia-Pacific Corporation.

On January 17, 2002, the Treasury Department and Internal Revenue Service released an Advance Notice of Proposed Rulemaking (ANPR) that describes rules and standards the Treasury Department and IRS expect to propose in 2002 in order to provide a framework for the treatment of expenditures incurred in acquiring, creating, or enhancing intangible assets. Announcement 2002-9 was subsequently published in the Federal Register (67 Fed. Reg. 3461) and in the Internal Revenue Bulletin (2002-7 I.R.B. 536). The Announcement invites public ,comment on the rules and standards set forth in the ANPR and also requests comments and recommendations for alternative rules. On behalf of Tax Executives Institute, I am pleased to submit the following comments.

Background

Tax Executives Institute is the preeminent association of business tax executives in North America with more than 5,300 members representing 2,800 of the leading corporations in the United States, Canada, and Europe. 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.

Members of TEI 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 professional training of our members enable us to bring an important, balanced, and practical perspective to the rules and standards that govern the application of section 263(a) to expenditures that result in taxpayers acquiring, creating, or enhancing intangible assets or benefits.

Taxpayers, the IRS, and courts, have long struggled with the distinctions between costs that are deductible when incurred and those that should be capitalized. Since the Supreme Court's decision in INDOPCO v. Commissioner, 503 U.S. 79 (1992), whether a particular expense may be deducted currently or must be capitalized has become a particularly troublesome issue. (1) While the IRS National Office has consistently said that INDOPCO did not alter the fundamental principles of capitalization, (2) the decision has been cited by revenue agents to justify adjustments capitalizing numerous expenditures, many of which have long been viewed as clearly deductible. As a result, the number, scope, and frequency of disputes between taxpayers and the IRS over such issues have escalated substantially. Indeed, the National Taxpayer Advocate identified capitalization issues as the most litigated issue for business taxpayers in the 1998 Report to Congress, and there is no sign the controversy has abated. In addition, the IRS's Large and Mid-Size Business Division has reported that more than 25 percent of its audit resources are devoted to capitalization issues in some industries. (3)

TEI has frequently urged the IRS to set forth a clear, consistent, administrable, and practical framework for addressing capitalization issues, including safe harbors and rules of administrative convenience that may be applied in evolving business environments without intensive analysis of each taxpayer's particular circumstances. Hence, TEI commends the government for issuing the ANPR and inviting public comments on the treatment of various costs related to the acquisition, creation, or enhancement of intangible assets or benefits. We believe that the consultative process will enable the government to issue rules that will reduce compliance and administration costs and minimize uncertainty and controversy for the benefit of both taxpayers and the government. Indeed, to minimize resources devoted to unproductive controversies, we recommend that the final rules not only be effective immediately; but also that guidance be issued stating that the government will not challenge a taxpayer's treatment of expenditures in prior years to the extent such treatment is consistent with the new rules. (4)

General Deductibility

The ANPR describes categories of expenditures for the acquisition, creation, or enhancement of intangible assets or benefits for which capitalization will be required. The government anticipates "that other expenditures to acquire, create, or enhance intangible, assets or benefits generally will not be subject to capitalization under section 263(a)." (5) TEI urges the government to formally adopt a rule of "general deductibility" and to make that rule explicit. To minimize uncertainty and curtail controversy, the proposed rules of administrative convenience for deductibility of expenditures outlined in the ANPR must constitute the principal and controlling guidance. During the past 10 years, a number of revenue rulings have been issued that were intended to quell controversies by according taxpayers deductions for specific expenditures. Regrettably, revenue agents have narrowly construed the rulings by characterizing many routine expenditures as "rare and unusual" and thus outside the scope of the ruling's general rule of deductibility. TEI encourages the government to include in the proposed regulations the explicit statement that expenditures, other than the cost categories specifically identified as subject to capitalization, will generally be deductible.

Twelve-Month Rule

The ANPR states that the government expects to propose a rule in which

capitalization under section 263(a) would not be required for an expenditure unless that expenditure created or enhanced intangible rights or benefits for the taxpayer that extend beyond the earlier of (i) 12 months after the first date on which the taxpayer realizes the rights or benefits attributable to the expenditure, or (ii) the end of the taxable year following the taxable year in which the expenditure is incurred. (6) TEI supports broad application of the proposed 12-month rule. Where the future benefit or life of an asset is 12 months or less, it is unlikely that taxable income will be materially distorted by permitting a current deduction even where an expenditure produces an incidental benefit or has a life extending beyond the end of the tax year. In addition, many expenditures with a useful life of 12 months or less are apt to be regular and recurring in nature so a deduction for such items would likely produce a better matching of income and expenses. As a result, TEI believes that a broadly applied 12-month rule will significantly reduce controversy, will provide simplification for taxpayers, and is consistent with the government's objective of "translating general capitalization principles into clear, consistent, and administrable standards." (7)

The ANPR solicits comments "on how the proposed 12-month rule might apply to expenditures paid to create or enhance rights of indefinite duration and contracts subject to termination provisions. For example, comments are requested on whether costs to create contract rights that are terminable at will without substantial penalties would not be subject to capitalization as a result of the 12-month rule." (8)

For purposes of applying the 12-month rule, TEI recommends that the expected economic life of an intangible asset be the basis for measuring the period of the benefits. This is consistent with the principles of current law, including, among other rules, Treas. Reg. [section] 1.167(a), et seq. For example, where a taxpayer paid a fee to obtain a contract or lease for a term of 24 months, the fee would be amortized over 24 months.

In determining the expected economic life of an intangible asset, the ANPR does not indicate what rules might be prescribed regarding the application of the 12-month rule where renewal periods are included at the inception of the contract, lease, or the grant of government rights. TEI believes that only the initial period stated in the contract, lease, or government grant should be considered, unless at the time of the grant or the creation of the contract or lease there is a substantial likelihood that the grant, contract, or lease will be renewed. For this purpose, certain renewal rights should be ignored. Specifically, where a grant, contract, or lease provides for renewals at prevailing fair market prices or rates at the end of the term of the contract, renewal periods should be ignored because only the initial term is guaranteed. Indeed, where a right of renewal is subject to renegotiation of any material term at the conclusion of the initial term, the right is little more than an agreement to agree and the renewal period should be ignored. For example, an amount paid by a service provider to a sales agent (e.g., a commission) for a...