The Contours of 'Capital Expenditure' v Expense' (or Current Depreciation)

• Author: Deborah A. Geier
• Pages: 108-124

Chapter 4: The Contours of “Capital

Expenditure” v. “Expense” (or Current Depreciation)

In Chapter 1, you learned that business and investment outlays that qualify as current

“expenses” can be immediately deducted under §§ 162 and 212, respectively. In contrast, outlays

that are categorized as “capital expenditures” are nondeductible (regardless of whether incurred in

business, investment, or personal consumption activity) but create basis that can reduce the tax

base in the future (via depreciation or amortization deductions if the asset so qualifies or via

reduced gain or increased loss under § 1001 on a realization event). The common way to describe

why the distinction between an expense and a capital expenditure is important is because of the

time value of money; a dollar deducted today is worth more than a dollar that reduces the tax base

in a future year. The more specific or nuanced reason why this distinction is important is that the

capitalization principle is the defining difference between an SHS income tax and a consumption

tax, as you learned in Chapter 2. If Chris purchases shares of corporate stock for $10,000, he cannot

deduct that outlay under an SHS income tax because it is a capital expenditure. The basis thereby

created will reduce his tax base only in the future. In contrast, he would be able to deduct

immediately that addition to his savings in the purchase year under a cash-flow consumption tax,

and we have seen that consumption tax treatment is more favorable for Chris. Indeed, under the E.

Cary Brown yield-exemption phenomenon, the asset’s return, while nominally included in his tax

base in the future when withdrawn from investment, is effectively free from tax (to the extent not

exceeding the expected normal return) because earned on pre-tax dollars. Stated differently, if

Chris is permitted to deduct his $10,000 cost immediately, the tax consequences can be the same

as if he were not permitted to deduct that $10,000 immediately (as under an income tax) but were

permitted to exclude the investment’s return from tax (unlike under an income tax) between the

time that he (prematurely) deducted the outlay and the time that he should have been permitted

deduction.

For these reasons, the issue of which outlays should properly be categorized as capital

expenditures is much more important than one of mere timing, as you sometimes read in court

opinions. Characterizing an outlay as a current “expense” that should properly be characterized as

a “capital expenditure” can provide inadvertent consumption tax treatment through the back door.

Congress has shown that it knows well how to enact consumption tax provisions when it wants

to do so. Chapter 2 contained a list of some of those provisions. These provisions are conscious

deviations from the SHS income tax norm, which otherwise provides the default position regarding

the core structure of the Internal Revenue Code. Because Congress knows how to deviate from

SHS principles when it wants to do so, one can argue that administrators of the statute and courts

should be careful to protect income tax values by applying a strong capitalization principle (in

ambiguous circumstances) to avoid providing consumption tax treatment inadvertently through

the manipulation of doctrine, without the blessing of Congress.

The issue becomes even more important if borrowed money is used to make the outlay at issue.

You learned in Chapter 2 that business and investment interest (generally deductible under an

income tax) should be nondeductible under a cash-flow consumption tax that permits borrowed

principal to be excluded. In other words, the tax arbitrage possibilities of combining the income

tax rules pertaining to debt (an interest deduction) with respect to an investment that is otherwise

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accorded consumption tax treatment (where interest would not be deductible) would provide a tax

outcome that is more favorable than would occur under either a pure SHS income tax or cash-flow

consumption tax. Because the stakes are so high, the issue of which outlays must be capitalized

has been highly litigious, particularly during the time surrounding the INDOPCO decision, below.

This chapter will begin in Part A. by considering outlays pertaining to the acquisition or creation

of an intangible asset (typically referred to merely as an “intangible”). The Supreme Court’s 1992

INDOPCO decision made tax headlines and caused Treasury to open a new regulations project to

revamp completely the capital expenditure regulations in an effort to bring more certainty to this

area. Treasury divided the project into two phases, with the first devoted to intangibles (at issue in

INDOPCO itself) and the second devoted to tangible assets. The intangibles regulations were

finalized in December 2003. The regulations pertaining to tangible assets, considered in Part B.,

took much longer. The final regulations were made effective as of January 1, 2014.

Part C. will then consider the related issue pertaining to which indirect costs (such as labor

expenses, state taxes other than income taxes, production-period interest, and depreciation)

incurred in the process creating an asset must be capitalized into the basis of that newly created

asset rather than immediately deducted. The Supreme Court’s 1974 decision in Idaho Power led

Congress to enact § 263A in 1986, which codified more precise rules to implement the idea

illustrated in Idaho Power.

A. Outlays pertaining to intangibles

For a pre-INDOPCO case involving the purchase of an intangible, consider Commissioner v.

Boylston Market Association,1 in which the taxpayer purchased and paid for, in Year 1, insurance

coverage for his business that would last for three years. The taxpayer sought to deduct the entire

payment in Year 1 as a business expense under § 162, but the court agreed with the government

that the purchase of insurance coverage that lasted three years was a nondeductible capital

expenditure, not a current expense, because the coverage lasted substantially beyond the end of

Year 1. Rather than a current wealth decrease, the payment represented merely a change in the

form in which wealth was held when the company purchased an intangible (insurance coverage)

that lasted well beyond the year of payment. Whether the basis created on the making of that

nondeductible capital expenditure is amortizable over the three-year period of insurance coverage

under the depreciation provisions is a separate question from the issue of whether the outlay is, in

the first instance, a capital expenditure or expense. We shall study the depreciation provisions in

Chapter 13. Right now, we are interested solely in exploring the threshold capitalization question.

INDOPCO involved the proper treatment of the costs incurred by National Starch (renamed

INDOPCO after the transaction) in the course of the acquisition of its stock by another corporation,

Unilever. While such facts (a corporate acquisition) appear to be far afield of the typical facts

found in a course devoted to the taxation of the individual, the way in which the court analyzed

the capital expenditure issue goes far beyond the fact pattern before it. You need not understand

the underlying structure (or tax consequences) of the acquisition transaction, itself, to appreciate

the discrete issue analyzed here: whether the legal and investment banking fees incurred by

National Starch/Indopco (the target corporation) in connection with the acquisition of its stock by

Unilever should be categorized as a current business “expense” (deductible under § 162) or as a

1 131 F.2d 966 (1st Cir. 1942).