OK, so it's not as catchy as the old ILGWU jingle ("Look for the union label. . ."), but it's still good advice to taxpayers. Watch out for the INDOPCO guidance, expected to be issued in final form by year-end. (At present, the guidance is in the form of proposed regulations: REG-125638-01.)

What is the "INDOPCO guidance?" It's shorthand for guidance on the contentious issue of whether to capitalize or deduct certain expenditures, in this case, those relating to intangible assets. The guidance takes its name from the 1992 Supreme Court decision in INDOPCO, Inc. v. Comr., 112 S. Ct. 1039, in which the Court held that $2.75M in investment banking fees (incurred by a target corporation in connection with its friendly acquisition) must be capitalized. The Court reasoned that capitalization was required because the fees could be expected to produce a "significant future benefit" once the acquisition was consummated.

If ever a tax case rates as a Pyrrhic victory, it's INDOPCO. Perhaps Government lawyers envisioned a future in which taxpayers would acquiesce to the capitalization of all kinds of intangible expenditures, some with little chance of  cost  recovery. (That's what happened in the INDOPCO case itself because, practically speaking, the investment banking fees became permanently non-deductible.) If that was the lawyers' expectations, they were in for a surprise.  Instead of taxpayer capitulation, what the Government reaped was a decade of controversy with taxpayers resisting the unrealistic "significant future benefit" standard of INDOPCO.  By 2001, Treasury was ready to throw in the towel, conceding that fully 25% of the IRS's examination resources were being consumed by INDOPCO issues. (This concession bears out the wisdom of former Chief Counsel B. John Williams who, though himself an experienced litigator, was dubious about setting tax policy through litigation.)

When finalized, the INDOPCO regulations should effect a sea change in the way IRS examinations are conducted. How big a change?  Enough to cause one critic to brand the forthcoming rules "taxpayer giveaways." Why such harsh criticism? Primarily because the critics believe Treasury has shown a preference for pragmatism over principle. The proposed rules do this by reversing the usual polarity of the debate:  instead of capitalization being the norm, with deductions the exception, the proposed  rules turn the tables upside down.  In substance, if not in form, the norm is now deductions, subject to the following four exceptions:

·         acquired intangibles, such as equity interests in a corporation or partnership; debt instruments; financial instruments; goodwill; customer lists; patents and copyrights; franchises; trademarks; etc.

·         created intangibles similar to many, but not all, of the items listed above (equity interests in a corporation or partnership; debt instruments; financial instruments; but not goodwill or customer lists).

·         separate and distinct intangible assets (this terminology derives from a 1971 Supreme Court decision, Comr. v. Lincoln Savings & Loan Association, 403 U.S. 345).  Lincoln Savings was considered the controlling authority in this area until it was distinguished, at the Government's urging, by the Supreme Court in INDOPCO.

·         last, and very much least, are those expenditures defined as subject to capitalization under the "significant future benefit" standard of INDOPCO. Before readers suspect Treasury is trying to rehabilitate the INDOPCO doctrine, it should be emphasized that Treasury has put this category in the deep freeze. No expenditure will be so categorized unless it is identified as such in future published guidance, e.g., by regulation. Even then, the categorization will be prospective only.

At this point, the analysis of the proposed rules gets complicated.  The exceptions requiring capitalization are themselves subject to exceptions allowing deductions. Since this drafting wizardry is taxpayer-friendly, don't expect any complaints about complexity.(Funny how taxpayer objections seem to fade when the complications run in their favor.)

The first of the taxpayer-friendly exceptions is the so-called 12-month rule, which operates as an exception to the created intangible exception. Expenditures related to certain created intangibles are deductible if they yield only a short-term benefit, i.e., not more than twelve months long. This rule is consistent with the taxpayer-favorable result in U.S. Freightways Corp. v. Comr., 270 F.3d 1137 (CA-7 2001), a case involving vehicle fleet operating expenses.

The second of the taxpayer-friendly exceptions is a de minimis rule which operates as another exception to the created intangible exception. Expenditures related to certain created intangibles are deductible if they do not exceed $5000. Note this rule has a "cliff effect," i.e., no part of an expenditure totaling more than $5000 is deductible.

In contrast to the bulk of the proposed regulations, one section has met with considerable taxpayer criticism: the rules covering transaction costs. Proposed reg. § 1.263(a)-4(e). As used in the proposed regulations, this term includes "ancillary" costs incurred to facilitate the acquisition of a capital asset. This linkage is consistent with the decision of the Supreme Court in Woodward v. Comr., 397 U.S. 572 (1970 ), holding that fees incurred in connection with a stock acquisition were subject to capitalization. Nothing particularly controversial in the proposed regulations here; Woodward has been the controlling authority for over 30 years. What has provoked taxpayer criticism is the line that Treasury has drawn, in the context of acquiring a new business, between investigative and facilitative costs. The former, though not currently deductible, are amortizable under §195. The latter must be capitalized under § 263. 

This in not Treasury's first venture into the investigative vs. facilitative controversy. In Rev. Rul. 99-23, Treasury established a "whether-or-which" test for distinguishing these costs. Under this test, the boundary into capitalization was crossed when a taxpayer decided both whether to acquire a new business and which new business to acquire. Taxpayers, understandably reluctant to concede capitalization, argued that final decisions on these two questions tended to occur late in the acquisition process. IRS, in turn, quickly realized that the "whether-or-which" test allowed taxpayers considerable flexibility to argue for delay. Accordingly, the proposed regulations would replace the "whether-or-which" test with a "bright line" rule, a rule intended to suppress taxpayer arguments by imposing an arbitrary date after which costs must be capitalized.  The "bright line" is the earlier of two dates: when a letter of intent is issued or when the Board of Directors approves the acquisition proposal. Treasury's critics believe the line has been drawn too early in the acquisition process, thus leading to more widespread capitalization. It remains to be seen whether Treasury will yield on this issue.