The final INDOPCO regulations: a primer.

• Author: Atkinson, James L.

Twelve years after the Supreme Court's landmark (or nefarious, depending on your perspective) decision in INDOPCO, Inc. v. Commissioner, (1) the Treasury Department and the Internal Revenue Service have issued final regulations attempting to put the "significant future benefit" genie back in the bottle. The regulation represents a policy-level response to what many had perceived to be zeal on the part of some IRS field personnel in applying the Court's "significant future benefits" standard and, in many respects, represents a sea change in the government's traditional perspective on capitalization. This article provides an overview of the new regulations and offers insights into their development and likely implications.

The Road Here

The road from the Supreme Court's 1971 decision in Lincoln Savings & Loan (2) to its 1992 decision in INDOPCO, as well as the tumultuous aftermath of that later decision, is heavily documented and need not be recounted here in detail. In Lincoln Savings, the Supreme Court required a financial institution to capitalize payments made to a government-administered insurance fund where the financial institution had a continuing property interest in the fund. The Supreme Court required capitalization on the grounds that the payments created a separate and distinct asset having a useful life extending substantially beyond the end of the taxable year. (3)

Courts diverged in their interpretation of Lincoln Savings, with some reading the case to mean that an expenditure had to be capitalized only if it gave rise to a separate and distinct asset, (4) while other courts (and the IRS) interpreted Lincoln Savings to mean only that the creation of a separate and distinct asset is one--but not the only--basis for capitalization. (5) The Supreme Court in INDOPCO confirmed that the second interpretation is correct. In explaining its holding, the Court said that creation of a separate and distinct asset is a sufficient but not necessary predicate to capitalization. Capitalization also may be required where the costs give rise to a significant future benefit. (6)

The IRS National Office took the position that INDOPCO did nothing more than clarify what had been the applicable law all along and that a cost that was not capitalizable before INDOPCO was not capitalizable solely by reason ofINDOPCO. (7) Nonetheless, there was at the very least a perception that IRS field agents read INDOPCO as creating a new category of capitalizable costs. (8) In public remarks, senior IRS and Treasury officials downplayed this perception, suggesting the increase in capitalization issues was due in part to the changing nature of the American economy and the emergence of an increasing array of intangibles that had never before been scrutinized under section 263. (9) Nonetheless, the perception persisted.

Whether in response to the emergence of a new generation of intangibles that did not fit neatly within the decades old template of capitalization principles, its string of losses before appellate courts permitting deductions for an array of costs, (10) or the continuing perception of revenue agents gone wild, the National Office and Treasury committed to issue regulations fundamentally changing the capitalization landscape. The resulting final regulations were published in January 2004. (11)

The Regulations

The final INDOPCO regulations appear as Treas. Reg. [section] 1.263(a)-4, applicable to costs incurred to acquire or create intangibles, and Treas. Reg. [section] 1.263(a)-5, applicable to costs incurred to facilitate the acquisition of a trade or business, a change in the capital structure of a business entity, and certain other transactions. The two sections share a number of similarities, but are best considered separately.

Acquisition or Creation of Intangibles

The analysis underlying Treas. Reg. [section] 1.263(a)-4 essentially follows three steps: (a) what intangibles fall within its scope; (b) what activities with respect to those intangibles require capitalization; and (c) what costs relating to those activities must be capitalized.

1. Which Intangibles?

   The final regulations require capitalization of (i) an amount paid to acquire any intangible; (ii) an amount paid to create certain but not all intangibles; (iii) an amount paid to create or enhance a "separate and distinct intangible asset"; and (iv) an amount paid to create or enhance a "future benefit," but only under certain circumstances.

   Two extremely important concepts are embedded in this section. The first is the government's use of a narrow definition of "separate and distinct intangible asset," presumably to prevent expansive interpretations of the Lincoln Savings "asset" concept as a means around the regulations' constriction of the INDOPCO "significant future benefit" standard. The final regulations define a "separate and distinct intangible asset" as a property interest of ascertainable and measurable value in money's worth that is subject to protection under applicable state, federal, or foreign law, and the possession and control of which is intrinsically capable of being sold, transferred, or pledged separate and apart from a trade or business. Critically, the final regulations define "separate and distinct intangible asset" as a property interest containing each of these characteristics, rather than stating the characteristics as simply factors to consider in determining whether an intangible rises to the level of an asset. Although courts have considered each of these factors at various times in identifying a potential asset, this tripartite definition changes the substantive law defining an "asset," at least for this one purpose. In doing so, Treasury and the National Office converted what had been a facts-and-circumstances inquiry into a concrete definition with clearly defined boundaries, substantially less susceptible of creative or expansive interpretations.

   Perhaps tacitly acknowledging the purpose behind this restrictive definition, IRS officials have indicated informally that they do not plan to extend it to other situations requiring the identification of an asset, such as the forthcoming repair regulations. (12) This is unfortunate, because a single, unified definition of "asset" for all purposes of the capitalization rules--including the repair regulations as well as the uniform capitalization rules (13)--would further the goal of simplification.

   The second critical concept embedded in this section is the government's imposition of rigid controls on the use of the significant future benefit standard. The regulations require taxpayers to capitalize costs incurred to create or enhance a "future benefit identified in published guidance in the Federal Register or the Internal Revenue Bulletin ... as an intangible for which capitalization is required under this section." The practical effect of this provision is to retain the Supreme Court's "significant future benefit" standard, but to place control of that standard squarely within the purview of the senior leadership of the IRS and Treasury. Because nothing can be published in either the Federal Register or the Internal Revenue Bulletin without the concurrence of the Assistant Treasury Secretary (Tax Policy), the Commissioner, and the IRS Chief Counsel, no cost can now be capitalized under the significant future benefit standard unless (i) it is specifically identified in the final regulations as a capital expenditure, or (ii) the Assistant Secretary, the Commissioner, and the Chief Counsel all agree that the purported future benefit is in fact significant enough to require capitalization. This determination can no longer be made by revenue agents, branch-level attorneys within the National Office (such as through a technical advice memorandum), or other subordinate IRS personnel.

   Moreover, even if a new significant future benefit is identified in published guidance, the guidance will apply prospectively only. (14) This assurance will prevent unpleasant surprises during the examination process. The policy-level containment of the significant future benefit standard, along with the creation of the new presumption of deductibility for self-created intangibles (discussed below), was the government's primary means of putting the significant future benefits genie back in the bottle.

   The regulations rely heavily upon lists and examples rather than broad principles. For instance, the final regulations apply to the acquisition or creation of "intangibles." This key concept is left undefined, however, with its meaning derived only by reading the lists, categories, and examples in which the term appears. As a second illustration, the preamble explains that in order to avoid potential ambiguities or uncertainties regarding the meaning of the word "enhance," the final regulations delete the concept in favor of identifying specific circumstances involving capitalizable "enhancements" (such as upgrades in a membership). Again, rather than invite ambiguity or permit creative interpretations, the government chose to eliminate the concept altogether and to replace it with specific situations requiring capitalization. The regulations' heavy reliance on lists, specific categories, and detailed examples suggests that rather than invite another round of controversy on the proper interpretation to be given to a new set of general principles, the government chose to simply tell agents and taxpayers the specific costs that are to be capitalized.

2. Which Activities?

   Treas. Reg. [section] 1.263(a)-4 applies only to costs incurred to acquire any or to create some intangibles. Treas. Reg. [section] 1.263(a)-4(c) requires taxpayers to capitalize costs incurred in connection with the acquisition of a laundry list of intangibles, including, for example, an ownership interest in a corporation, partnership, or LLC; a variety of financial interests and products; insurance and annuity contracts...