Indopco v. Commissioner: the Supreme Court takes National Starch to the cleaners.

• Author: Grigsby, McGee

On February 26, 1992, the Supreme Court announced its decision in Indopco, Inc. v. Commissioner. (1) Justice Blackmun, writing for a unanimous court, affirmed the disallowance of deductions claimed by the taxpayer for legal fees and investment banking fees incurred by Indopco's predecessor, National Starch and Chemical Corporation, in connection with the friendly acquisition of National Starch by Unilever United States, Inc.

The Court's decision was anxiously awaited because of its potential impact on a significant segment of corporate America. The 1980s witnessed an extremely high volume, both in number and in dillar value, of corporate mergers, acquisitions, and reorganizations. Many of these transactions occurred in the context of friendly or hostile takeovers or attempted takeovers. The professional fees were commensurate with the size and number of the transactions. Consequently, many corporate taxpayers saw themselves as potentially affected by the decision in Indopco.

More fundamentally, legal fees and investment banker fees are not the only expenditures arguably affected by the Indopco decision. Commencing in the mid-1980s, field agents of the Internal Revenue Service began questioning taxpayers' treatment of a wide variety of expenditures associated with takeover transactions. At the same time, the IRS formed the Leveraged Buyouts Industry Specialization Program to formulate standardized positions on takeover issues and to provide support to agents in the field in connection with audit adjustments related to such transactions. (2)

As Indopco was wending its way through the courts, the scope of adjustments proposed by examining agents in connection with takeover transactions grew. Examples included proposed disallowances of expenditures associated with defending against hostile takeovers; expenditures associated with financing before, during, and after a transaction; expenditures associated with employee compensation, including severance payments and the exercise of options and early retirement; expenditures associated with unsuccessful or abandoned transactions; and expenditures of all types incurred months or years after the transactions were completed. Because Indopco was to be the Supreme Court's first pronouncement directly addressing takeover transactions, there was the potential that the decision would have farreaching implications.

1. OVERVIEW

   This article examines the Indopco decision in detail, describes what the decision does and does not address, explains the implications of Indopco in circumstances not covered in the opinion, and suggests some strategic considerations for the future. Specifically, the article concludes:

   * The holding of Indopco is deliberately crafted to be confined to the precise facts before the Court.

   * Indopco addresses only the disallowance of professional fees incurred by a target company in the course of a friendly takeover.

   * Such fees must be capitalized when they result in a significant long-term benefit to the taxpayer.

   * Professional fees incurred in connection with restructuring a corporation must be capitalized.

   * Indopco clearly rejects the proposition that the creation or enhancement of a separate and distinct asset is a prerequisite for capitalization.

   * Indopco does not otherwise establish any new standards for distinguishing between expenditures deductible under section 162 and those that must be capitalized under section 263.

   * The implications of Indopco for a friendly takeover that is devoid of resource-related benefits and corporate restructuring are far from clear.

   * The analysis in Indopco confirms that hostile takeover defense expenditures are currently deductible.

   * Traditional analysis and precedent remains intact for a wide variety of expenditures such as compensation, abandoned transactions, and normal post-transaction corporate operations.

   * Indopco suggests that corporate structure-related costs have a useful life equal to the period during which the structure created remains in place.

2. THE OPINION

   The opinion of Justice Blackmun, from beginning to end, makes two points very clear. First, the opinion addresses a very narrow set of facts: the proposed disallowance of professional charges incurred by a target company in the context of a friendly takeover. Second, the central holding is equally narrow: such charges must be capitalized when they result in a significant long-term benefit.

   The intention to render a decision in a narrow factual context is made unequivocal by the architecture of the opinion. The very first sentence of the opinion describes the factual situation with absolute precision. Parts I, II, and III of the opinion discuss the facts, the law, and the application of the latter to the former, respectively; then, the first sentence of Part IV (the summary) repeats the narrow set of facts within which the legal question is presented. It is as if these two sentences were bookends precisely placed to hold the opinion within closely circumscribed confines.

   That the central holding of the case is premised upon the finding of a significant long-term benefit is also evident from start to finish. In Part I of the opinion, there is marked emphasis on the lower courts' reliance on the finding of several long-term benefits. As so stated by the Court, the Tax Court "based its holding primarily on teh long-term benefits that accrued to National Starch," (3) and the Third Circuit "affirmed, upholding the Tax Court's findings that [the acquisition] served the long-term betterment of National Starch." (4)

   Part II of the opinion -- a sometimes puzzling discussion the law -- imparts a strong focus on the importance of the duration and extent of the benefits acquired. In describing the difference between expenditures deductible under section 162 and those that must be capitalized under section 263, the Court recounts the central principle of matching expenses and revenues, a concept essential to a long-term benefit analysis. (5) According to the Court, to the extent an expenditure creates a benefit of substantial duration and extent, the tax effect of the expenditure should be spread over time to match the revenues presumably derived from the benefit.

   The Court's reference to Justice Cardozo's landmark opinion in Welch v. Helvering (6) echoes this theme. The central issue is that the "decisive distinctions" between deductible expenditures and those that must be capitalized are often distinctions "of degree and not of kind." (7) Once a court determines that the degree of benefit is significantly longterm, the expenditure must be capitalized. Conversely, if the degree of the benefit is not sufficiently long-term, capitalization should not be required.

   In the light of the emphasis on long-term benefits, it is not surprising -- and was perhaps inevitable -- that the Court rejected Indopco's argument that Commissioner v. Lincoln Savings & Loan Association, 403 U.S. 345 (1971), established an exclusive, new test -- the creation or enhancement of an asset -- for identifying capital expenditures. According to the Court, Lincoln Savings stands only for the proposition that the "creation of a separate and distinct asset well may be a sufficient but not a necessary condition to classification of a capital expenditure." (8) The Court gives short shrift to the taxpayer's argument that failure to affirm the proffered Lincoln Savings test would leave taxpayers without a "principle basis" for distinguishing business expenses from capital expenditures. Indeed, the argument is dismissed in a footnote. (9)

   Part III applies the foregoing legal principles to the facts of the case, with the analysis concentrating almost exclusively on long-term benefits. First, the Court finds ample support in the trecord to affirm the lower courts' findings that the expenditures should be capitalized because they produced "significant benefits" extending "beyond the tax year in question." (10) The Court describes as "resource-related" benefits the availability to National Starch of Unilever's enormous resources and the potential for synergy with the Unilever organization. It then turns to corporate structure- related benefits that National Starch obtained. (11) With respect to the latter, the long-term benefit theme is sounded yet again when the Court describes these expenses as "incurred for the purpose of changing the corporate structure for the benefit of future operations." (12)

   Part IV consists of three sentences, the last of which simply states that the judgment of the Third Circuit is affirmed. The other two restate the conclusions found elsewhere in the opinion. Although there is no explicit repetition here of the long-term benefit analysis, the statement that the "acquisition-related expenses bear the indicia of capital expenditures" (13) creates no ambiguity since the entire opinion stands for the proposition that an essential characteristic of a capital expenditure is the production of long-term benefits.

   Apart from the central focus of the Court's analysis, there are two other lesser but supporting themes in the opinion: (1) the possibility that, in analyzing whether a claimed deduction must be capitalized, lower courts should generally eschew looking to the language of section 162 but should focus instead on the long-term benefit analysis; and (2) the suggestion that the outcome of this case is attributable to the taxpayer's failure to prove the absence of a benefit.

   First, the last paragraph of Part III deserves special mention. While the primary focus is on the corporate structure-related benefits obtained by National Starch, the last two sentences do not appear to be so limited. The penultimate sentence essentially says that although courts have sometimes used a section 162 analysis to deny deductions for corporate structure-related expenses, more frequently courts have found that capitalization is required because the purposes of the expenditures were...