Regulations on Capitalization of Intangible Assets
By Randy A. Schwartzman
The Internal Revenue Service recently issued much anticipated and long-awaited proposed regulations on the capitalization of amounts paid to acquire, create or enhance intangible assets. The issuance of these new regulations effectively marks the end of the INDOPCO era, which began when the IRS decided to use the prominent 1992 Supreme Court case, INDOPCO, Inc. vs. Commissioner (503 US 79), to argue that most costs associated with the acquisition, protection, development or enhancement of an intangible asset must be capitalized if there is a possibility that the expenditure would result in a future benefit.
Although the U.S. Supreme Court in its INDOPCO decision applied a significant future benefits standard to determine whether an expense should be capitalized, the IRS now agrees that it would have been difficult to use that standard as a premise for these new regulations, since that standard lacked the certainty and clarity needed to administer the tax laws. In determining expenditures that should be capitalized under the new proposed regulations, the IRS and the Treasury Deparment have now attempted to provide certainty by identifying specific categories of rights, and by focusing on those expenditures for which the courts have traditionally required capitalization, both before and after the INDOPCO decision.
The objectives of the proposed regulations are to reduce controversy, provide certainty, facilitate recordkeeping, reduce examination resources, and balance administrative and recordkeeping costs with clear reflection of income principles. These regulations overcome the long-standing presumption of capitalization by allowing a deduction for all intangible asset costs, except for those specifically listed in the regulations or contained in other sections of the code or regulations that must otherwise be capitalized.
While these rules currently are in proposed form, they can provide insight into the IRS’ current position on new and nonrecurring expenditures, and prepare taxpayers for potential favorable accounting method changes to come into conformity with the regulations when finalized (which the IRS hopes to accomplish this spring).
These broad regulations cover the capitalization of amounts paid to acquire, create or enhance an intangible asset. An intangible asset is defined as any intangible that is acquired from another person in a purchase or similar transaction; certain rights, privileges or benefits that are created or originated by the taxpayer and that are specifically identified in the proposed regulations; a separate and distinct intangible asset; or a future benefit that the IRS and Treasury identify in subsequent published guidance as an intangible asset for which capitalization is required.
Examples of acquired intangibles include ownership interests in a corporation, partnership, trust or other entity; a debt instrument; financial instruments such as letters of credit or futures contracts; going concern values under Section 197 regulations; a franchise, trademark or trade name; a customer list; and computer software.
This article focuses primarily on costs incurred in connection with merger and acquisition transactions. The new regulations in this area cover taxable and tax-free acquisitions and dispositions, restructurings, redemptions and other types of capital transactions.
The proposed regulations require capitalization of transaction costs that facilitate the acquisition, creation or enhancement of an intangible asset or that facilitate a restructuring or reorganization of a business entity or a transaction involving the acquisition of capital, such as a stock issuance, borrowing or recapitalization.
To eliminate much of the current uncertainty and controversy surrounding the tax treatment of acquisition costs, the IRS rejected the “whether-and-which” test of Revenue Ruling 99-23 to distinguish costs to investigate the acquisition of a new trade or business (amortizable as start-up costs under section 195) from costs to facilitate an acquisition (which are capitalized). The proposed regulations instead opt for a bright-line test whereby only costs that inherently facilitate an acquisition are capitalized. Consequently, all costs that occur before a preliminary agreement is reached are considered investigatory costs and are deductible immediately. A preliminary agreement generally occurs when a letter of intent is provided or when there is approval by the board of directors of the acquisition proposal.
Some of the costs that are considered to inherently facilitate an acquisition are expenditures for valuations, negotiation and structuring costs, and regulatory costs, among others.
The proposed regulations provide a “facilitate” standard for purposes of determining whether transaction costs must be capitalized, and are intended to be narrower in scope than previous standards. Some transaction costs that the IRS considered to be capital under previous standards—such as costs to downsize a workforce after a corporate merger—are not required to be capitalized under the facilitate standard. While such costs may not have been incurred without regard to the merger, these costs do not facilitate the merger itself.
The proposed regulations provide that an amount facilitates a transaction if it is incurred in the process of pursuing the acquisition, creation or enhancement of an intangible asset or in the process of pursuing a restructuring, reorganization or transaction involving the acquisition of capital.
Takeovers: Is It Better to Be Hostile?
The proposed regulations provide that transaction costs incurred by a taxpayer to defend against a hostile takeover of the taxpayer’s stock do not facilitate the acquisition and therefore are not required to be capitalized. However, if it is determined that an initially hostile acquisition attempt eventually becomes friendly, the rules require the taxpayer to bifurcate its costs between those incurred to defend against the acquisition attempt at the time the attempt was hostile, and those incurred to facilitate the friendly acquisition. Capitalization is required for costs incurred to facilitate the friendly acquisition.
Some costs may be viewed both as costs to defend against a hostile acquisition and as costs to facilitate another capital transaction. For example, a taxpayer may attempt to thwart a hostile acquisition by merging with a white knight, recapitalizing or issuing stock purchase rights to existing shareholders. The proposed regulations require capitalization of such costs, regardless of whether the taxpayer’s purpose in incurring such costs was solely to defend against a hostile acquisition.
Favorable Simplification Rules
The rules provide safe harbors and simplifying assumptions to reduce administrative, recordkeeping and compliance costs. The simplifying assumptions are administrative rules of convenience that allow taxpayers to deduct transaction costs they otherwise would be required to capitalize, without the need to maintain records or demonstrate how amounts were spent.
First, the employee compensation rule in the proposed regulations would apply to all compensation, including salary, bonus or commission. There have been many recent debates surrounding the extent to which capitalization is required for employee compensation related to the acquisition, creation or enhancement of an asset. To resolve controversy and eliminate the burden on taxpayers of allocating certain transaction costs among various intangible assets, the proposed regulations provide a simplifying assumption that employee compensation and overhead costs do not facilitate the acquisition, creation or enhancement of an intangible asset. The rule applies regardless of the percentage of the employee’s time that is allocable to capital transactions. For example, capitalization is not required for compensation paid to an employee of the taxpayer who works full time on merger transactions. The IRS has requested comments on whether a book/tax conformity rule should be imposed for employee compensation and overhead costs (i.e., if costs are capitalized for book purposes, then should they also be capitalized for tax purposes?).
Another simplifying assumption is that de minimis costs of $5,000 or less per transaction can now be deducted. However, no deduction would be allowed if transaction costs exceed $5,000. The proposed regulations provide that de minimis transaction costs do not facilitate a capital transaction and therefore are not required to be capitalized. These rules clarify that the de minimis rule applies on a transaction-by-transaction basis. However, a single transaction may involve the acquisition of multiple intangible assets. If that is the case, the proposed regulations also clarify that if transaction costs (other than the compensation rule discussed above and the overhead rule) exceed $5,000, no portion of the costs is considered de minimis under the rule, and all of the costs (not just the cost in excess of $5,000) must be capitalized.
There also are proposed rules for aggregating costs allocable to a transaction. While taxpayers generally must account for the actual costs allocable to each transaction, the proposed regulations permit taxpayers to determine the applicability of the de minimis rules by computing the average transaction cost for a pool of similar transactions. The IRS recognizes that this method of average cost pooling could result in a skewed average cost when de minimus costs are combined with other very large transaction costs. As a result, the Service has requested comments on the use of the average cost pooling methodology.
The proposed regulations also provide that certain amounts, including transaction costs paid to create or enhance intangible rights or benefits for the taxpayer that do not extend beyond a 12-month period, be treated as having a useful life that does not extend substantially beyond the close of the taxable year. As a result, these amounts generally are not required to be capitalized under the proposed regulations. (Existing regulations require taxpayers to capitalize expenditures that create an asset having a useful life substantially beyond the close of the taxable year.)
On the other hand, amounts paid to create rights or benefits that do extend beyond the period prescribed by the 12-month rule must be capitalized in full, and no portion of these amounts would be considered to come within the scope of the 12-month rule. The 12-month rule does not apply to amounts paid to create or enhance financial interests, or to amounts paid to create or enhance self-created amortizable section 197 intangibles.
The proposed regulations also clarify the interaction of the 12-month rule with the economic performance rules contained in section 461(h) of the code. In the case of a taxpayer using the accrual method of accounting, section 461 requires that an item be incurred before it is taken into account through capitalization or deduction. For example, under the economic performance rules, amounts prepaid for goods or services generally are not incurred, and therefore may not be taken into account by an accrual method taxpayer, until the goods or services are provided to the taxpayer (subject to the recurring item exception). Thus, the 12-month rule provided by the regulations does not permit an accrual-method taxpayer to deduct an amount prepaid for goods or services where the amount has not been incurred under section 461.
On the other hand, economic performance for items such as prepaid insurance and licenses occur immediately. Two very favorable examples contained in the regulations demonstrate how a deduction is obtained for advance payments for insurance and licenses that cover periods extending into the next taxable period. Once these regulations are finalized, the IRS will be inundated with requests to change to this more favorable method of accounting for qualifying prepaid expenditures.
15-Year Safe Harbor Amortization
Consistent with the treatment of section 197 intangibles, these rules also propose a 15-year safe harbor amortization period for certain created intangible assets that do not have a readily ascertainable useful life. For example, amounts paid to obtain certain memberships or privileges of indefinite duration would be eligible for the safe harbor amortization provision. Under this safe harbor, amortization is determined using a straight-line method with no salvage value. Any exception of course should exist for intangibles that have traditionally been disallowed under other provisions (e.g., country club dues). While practitioners had hoped for a shorter amortization period of, say, 60 months, to be consistent with the treatment for start-up costs or organizational costs, a 15-year amortization period was selected so as not to create tension with the provisions of section 197.
The safe harbor amortization period does not apply to intangibles acquired from another party or to self-created financial interests. These intangibles generally are either not amortizable, are amortizable under section 197, or are amortizable over a period prescribed by other provisions of the code or regulations. The safe harbor amortization period also does not apply to self-created intangibles that have readily ascertainable useful lives on which amortization can be based. Existing law permits taxpayers to amortize intangible assets with reasonably estimable useful lives. For instance, prepaid expenses, contracts with a fixed duration, and certain contract terminations have readily ascertainable useful lives on which amortization can be based. Prepaid expenses are amortized over the period covered by the prepayment.
The safe harbor amortization period does not override existing amortization periods such as the 36-month life for certain computer software under section 167, the rules for determining the amortization period for bond premium under section 171, the amortization period for costs to acquire a lease under section 178, and of course the 15-year life for certain section 197 intangible assets. Finally, the 15-year safe harbor does not apply to amounts paid in connection with real property owned by another. The proposed regulations provide a 25-year safe harbor amortization period for those amounts.
Are These Rules Favorable to the Taxpayer?
The proposed regulations are more taxpayer friendly than the current, more subjective guidance.
These regulations will be effective when final rules are published. Although they haven’t been finalized as yet, taxpayers and practitioners can use the proposed regulations as a guide to understand the current IRS position. At last, the INDOPCO era has ended!
Randy A. Schwartzman, CPA, MST, is a tax partner with BDO Seidman, LLP, and is a member of the NYSSCPA’s Closely Held and S Corporations Committee as well as chairman of the Society’s Mergers and Acquisitions Committee.
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