Copyright (c) 1994 Tax Analysts

Tax Notes

 

JUNE 6, 1994

 

LENGTH: 17482 words 

 

DEPARTMENT: Special Reports (SPR) 

 

CITE: 63 Tax Notes 1323 

 

HEADLINE: 63 Tax Notes 1323 - CAPITALIZATION AFTER THE GOVERNMENT'S BIG WIN IN INDOPCO. 

 

AUTHOR: Johnson, Calvin H. 

 

SUMMARY:

 

   Calvin H. Johnson is professor of law at the University of Texas. This article is based on a presentation made to the 41st Annual University of Texas Taxation Conference (October 28, 1993). 

 

   Professor Johnson argues that, after INDOPCO v. Commissioner, expenditures are capitalized if they have 'significant future value.' Professor Johnson applauds the 'significant future value' test as good theory and good accounting, because costs with significant future value are investments and, in an income tax, investments need to be capitalized. There is a prime directive in an income tax, he argues, which is that costs should be capitalized until adjusted basis equals the value of the investment. Professor Johnson applies the theory to argue for capitalization of costs of reorganizations (including those that started as hostile offers), of prepaid fees, of business expansion costs, of repair or remedial costs and of certain environmental costs. He argues, for instance, for remedial expenditures that the losses caused by prior accidents or events should not be mingled and confused with the new remediation investment. Prior losses do not justify the expensing of new investments, he argues, even if the investments are remedial. 

 

   Professor Johnson contends, however, that capital expenditure theory does not comfortably describe the costs in INDOPCO itself: Unilever, the acquiring company in INDOPCO, was said to have a permanent investment from fees paid by the target corporation to try to get Unilever to sweeten its offer. The fees were hostile to Unilever and probably gave it no future value. The fees, however, should not have been deductible either because they were costs of tax-deferred sales or because the fees were dividends. Taxpayer's counsel 'swung for the fences,' Johnson asserts, trying to get a deduction for reorganization fees and in swinging wildly and missing, it gave the government an important capital expenditure victory. 

 

   The author wishes to thank his colleagues Joe Dodge, Tom Evans, and Mark Gergen for helpful comments and suggestions, without however 

 

TEXT:

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                               Table of Contents

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I.   Basis Should Describe the Investment              1324

     A.   The Prime Directive                          1324

     B.   The Role of Materiality                      1326

     C.   The Role of Nontax GAAP                      1326

II.  The Decision in INDOPCO                           1327

     A.   The Dividend Alternative                     1328

     B.   The Matching Alternative                     1329

     C.   The Separate and Distinct Asset Argument     1330

     D.   INDOPCO Fees Under New Section 197           1331

     E.   Other Takeovers                              1331

III. Broader Application of Future Benefit Test        1332

     A.   Prepaid Fees                                 1332

     B.   Business Expansion Costs                     1334

     C.   Remedial Costs                               1334

     D.   Environmental Costs                          1338

IV.  Conclusion and Summary                            1340

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   In INDOPCO v. Commissioner, /1/ the Supreme Court held that National Starch Corporation had to capitalize the $2.7 million it paid in professional fees when it was acquired by Unilever Corporation in a tax-free acquisition. The professional fees, the Court held, 'produced significant benefits . . . beyond the tax year in question. . . .' /2/ There was no requirement, the Court decided, that the fees produce a separate and distinct asset. /3/ 

 

   INDOPCO has not won any popularity trophies from the tax bar. The bar has asked that INDOPCO be 'limited to its facts,' /4/ 'narrowly construed,' /5/ and viewed as driven by 'unique facts.' /6/ The bar has asked that INDOPCO's language not be 'stretched,' /7/ 'overzealously applied,' /8/ nor used in a 'broad scale attempt' /9/ to capitalize expenditures heretofore immediately expensible. /10/ INDOPCO, it is said, does not give the IRS authority to capitalize the costs of acquiring or creating a 30-year asset. /11/ 

 

   This article argues that INDOPCO is a successful opinion by the Court, right on both the issue before the Court and on the broad standard to be applied to other cases. The bar is letting its boosterism or briefing positions infect its writing. Costs with significant future value are investments and in an income tax, investments need to be made and continued with nondeductible moneys. Except where the costs are too small or the future benefits are too speculative to count, costs with future value need to be capitalized. INDOPCO is good law, good accounting, and good economics. The impact of INDOPCO should be wide and salutary. 

 

   Part I argues that costs with future value are investments that are capitalized under the norms of an income tax. It also discusses the role of materiality and of nontax accounting. Part II discusses target-side takeover expenses, which was the specific issue before the INDOPCO court. It concludes that INDOPCO is such a threatening case because the expenditures at issue were dividends, justified primarily by benefits at the shareholder level, and that the future benefits on the corporate level were ephemeral indeed. Part III discusses the application of INDOPCO to a number of current controversies, including prepaid fees, business expansion costs, and remedial and experiment costs. It concludes that INDOPCO will lead to capitalization in a number of areas, even in the face of prior case law tolerating expensing.

 

 

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                    I. Basis Should Describe the Investment

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    In INDOPCO, the Court capitalized professional fees because they provided significant future benefits. The 'future-benefits' standard is consistent with good economics and good accounting. Costs with future value are investments. In an income tax, failure to capitalize investments distorts the competition between investors and among investments in ways that will do economic harm.

 

 A. The Prime Directive 

 

   There is an economic norm, a 'prime directive,' by which capitalization law is judged in an income tax. The prime directive asks the question, 'Does basis equal the investment value of the costs?' If basis is higher than the investment value, too much has been capitalized or not enough has been written off and the taxpayer has been mistreated. If basis is lower than investment value, however, not enough has been capitalized or too much has been written off. Investment value is the value of the costs internally, viewed as a fund, like a savings account producing interest income. If the investment produces or is viewed as producing income at the prevailing interest rates, then the investment value of a cost is the discounted present value of the future cash flows that will come from the costs. Costs can have investment value internally, even if they have no external or marketable value that someone else would pay for. 

 

   Accounting methods useful for a national mass tax, such as the federal income tax, have to use simplified accounting conventions that cannot even pretend to ascertain the present value or investment value of costs under specific facts. Still, a simplified accounting convention is judged by how closely it can be expected to make basis approach the investment value of a cost. Conventions that are expected to get closer to the prime directive are better than conventions that are farther away. 

 

   Violation of the prime directive makes the tax system worse. One can identify and tax the real income from an investment only if the investment is made and continued with 'hard money,' that is, with after-tax, nondeductible amounts. Investments made with 'soft money,' that is, with deducted or untaxed amounts, are taxed at effective tax rates lower than the statutory norms. The lower effective tax rate means that high-bracket investors will drive out lower bracket competitors and that poorer investments, judged by their economic merit, will win out over better ones. 

 

   Deducting an investment is like exempting its subsequent income from tax. As shown in Table 1, the ability to make an investment with soft money can ordinarily be expected to be as valuable as not having to pay tax on the income:

 

 

 

 

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                        Table 1. Soft Money and Exempt

                              Investment Compared

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                                   (A)            (B)

                                                Soft-Money

                                Hard-Money      investment

                                investment     (noncapitalized

                               (e.g., savings  costs, e.g., farm

                               account, bond)  planting, R&D)

1. Salary or other income          $ 100.00        $ 100.00

2. Tax (at 41%)                     (41.00)       no tax

3. Investable amounts (i.e.,

line 1 minus line 2)                 59.00         100.00

4. 10% profit (income)               64.90         110.00

5. Tax on return (at 41%)           miraculous      45.10

                                    exemption

6. After tax                         64.90          64.90

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   The 'no tax' on investable amounts (cell 2B of Table 1) is as valuable as the 'miraculous exemption' of tax on income (cell 5A) when the tax rates remain the same. If tax rates drop (i.e., line 2 is higher than line 5), the cell 2B tax exemption is more valuable than a cell 5A tax exemption. 

 

   The results of the table can be generalized, by algebra, for all tax rates (with line 2 = line 5) and all return rates (line 4). /12/ With expensing of investments, tax does not reduce the investors' pretax rate of return from the investment. The 'effective rate' of tax on the investment is zero. /13/ 

 

   The advantage arises because soft-money investments will be larger than hard-money investments, for any given after-tax cost. The initial soft-money investment will be larger than the equal-burden, hard-money investment by a factor of 2 when the tax rate is 50 percent, by a factor of 1.5 when the tax rate is 33 percent, and in general by a factor of 1/(1-t) for tax rate t. The larger investment, possible with soft money, offsets the tax that must be paid on the subsequent income. The proposition that the ability to make investments with soft money is ordinarily as valuable as an exemption for subsequent investment income is a staple of modern tax economics. /14/ 

 

   1. Reduced effective rate. If basis is lower than the real income-producing value of the investment (but not zero), the effect is to lower real effective tax rate to a fraction of the normal statutory tax rate. Similarly, writing off investments at a rate faster than the real decline in income-producing value will mean a lower-than-normal overall tax rate on the investment. If there is some basis, but less than the real income-producing value of the investment, the real or effective tax rate is above zero, but not as high as the normal statutory tax rate. 

 

   2. High brackets drive out low. Soft-money investing discriminates in favor of higher bracket investors. Investors otherwise facing high effective tax rates (e.g., on stock, bonds, and savings accounts) buy up soft-money investments that have zero or low effective tax rate. Investors who have zero tax rates because of their statutory tax status /15/ or net operating losses will not pay anything for the privilege of a low effective tax rate on soft-money investments. Low tax rate investors /16/ will not pay much for tax exemption. Thus, high tax bracket taxpayers will tend to outbid low- tax or tax-exempt investors, drive them out of the market, and monopolize access to the expensed investment. If high-bracket taxpayers do not succeed in driving out lower tax competitors, it is only because the price they pay for the investment does not reflect the value of tax preference they receive and, in that case, the bidders are keeping for themselves, for their private welfare, the benefits of the lower effective tax rate. Noncapitalization tilts a level playing field in favor of the highest tax investors. The value of a soft-money investment to a given investor will depend on the tax rate the investor faces. Only by keeping basis equal to income producing value of the investment is it possible to have the value of the investment be independent of the investor's tax rate.

 

   3. Enforce the level playing field. The courts need to enforce fair play with a strong law of capitalization. When Congress requires that accounting methods clearly reflect income, /17/ that implies that the courts should capitalize costs to keep basis up to the investment value of the asset. Only then will the real economic rate of tax (effective tax rate) be kept up to statutory norms, and only then will tax be neutral in the competition between investments and among investors. 

 

   Sometimes Congress has mandated expensing for costs with future value, /18/ but the preferential tax rate that expensing affords should never be presumed without a clear congressional order. Within an income tax system that generally requires that investments be made with hard money, the soft-money privilege is an extraordinary subsidy that is like a miraculous tax exemption. 

 

   4. Unrealized appreciation. The federal income tax is still a realization tax, i.e., it does not tax increases in the value of an investment prior to sale, receipts or other realization event. There are exceptions (like original issue discount /19/ and mark-to-market for securities dealers /20/) and the exceptions are growing. But even if realization is a weak principle, the tax system still ordinarily requires it. Unrealized, untaxed appreciation is part of the holder's investment, but it is not a taxed, hard-money part. Sometimes the prime directive, that basis equal the investment, can be saved in face of the nontaxation of unrealized appreciation: one simply views the original, unappreciated investment as generating above-market returns. Since unrealized appreciation goes away when it is sold, there are at least restraints on the tax-biased bidding we would see for other soft-money investments. Sometimes, however, unrealized appreciation simply must be allowed for administrative convenience. But our failure to tax unrealized appreciation does not mean that we must allow deduction for costs that remain investments. We do not tax unrealized appreciation on land or corporate stock, for instance. Nevertheless, we also capitalize the cost of acquiring those investments. 

 

   5. Allowing losses. Permanent basis is a fine result for permanent capital, but capital that shrinks or disappears should be written off. The prime directive also is violated if investment value shrinks below tax basis. The courts have not been very responsible about telling taxpayers when and whether costs may be depreciated in future years not before the court. /21/ Courts should specify, at minimum, whether basis is depreciable and show how to determine when basis is recovered.

 

 B. The Role of Materiality 

 

   A national tax system, applied to ordinary souls, tolerates some departures from good theory for immaterial costs. The rules are like 'gimme rules' or 'winter rules' for golf -- you can sometimes get credit for the hole when the putt gets close. Costs that are investments under good theory are sometimes expensible in practice. Some costs are so small or immaterial that attaining a clear reflection of income is not worth the accounting effort. 

 

   There is, however, a statutory definition of immaterial or insignificant costs in the fringe benefit area that seems attractive for all tax questions, including capitalization. De minimis fringe benefits are those not worth the accounting effort. /22/ A proper understanding of how worthwhile capitalization is, however, leads to capitalization after a rather low threshold. Since failure to capitalize is the same as not taxing subsequent income, capitalizing investment costs will be worthwhile for tax purposes, whenever the subsequent income is worth taxing.

 

 C. The Role of Nontax GAAP 

 

   Accounting theory reinforces the INDOPCO significant-future- benefit test and the economic norm that basis should equal value. If the costs will produce future income, accountants capitalize the costs to put them on the balance sheet so that the costs are carried over to the future years the costs relate to or carried over until the costs expire. An asset in accounting theory is not necessarily a tangible, salable, or salvageable thing, or anything useful as collateral. Accounting capitalizes prepaid salary, rent, or insurance premiums, for instance, although the costs have no external or marketable value, because they relate internally to future income the firm can expect. 

 

   Accounting theory, moreover, does not justify writing off an asset or writing down the costs to below the investment value of the costs. If costs still have value, they still should appear on the balance sheet. The balance sheet can be thought of as a bank account that is like the firm. The balance sheet in theory should specify what amount of a bank account the firm is like, so that investors can tell what future income can be expected from the firm. 

 

   Because of institutional pressures for understatement, however, generally accepted accounting principles ('GAAP') commonly lead to basis accounts that are too low to serve for tax purposes. GAAP, as administered by the Financial Accounting Standards  Board ('FASB') is not synonymous with good accounting theory. FASB- GAAP is a mandatory, though incomplete, set of rules for reporting books for SEC purposes to existing and potential investors and creditors. FASB-GAAP is a system of regulation intended primarily to control management puffery, that is, overstatement of income and assets. GAAP accounting is conservative by tradition and fundamental instinct. Debts are resolved in favor of understatement of assets and income. When FASB accountants agonize about capitalization, they are worrying about overcapitalization, not about the adequacy of basis. 

 

   For tax purposes, by contrast, the regulatory problem primarily is to control management understatement of income and basis. Not surprisingly, management puffs up taxable income only in uncommon situations. GAAP assets might be viewed as a floor below which the reporting firm should not drop for tax purposes -- GAAP income is declaration against interest for income tax purposes -- but GAAP is not intended to insure that basis remains adequate. GAAP, with its fundamental principle of conservatism cannot be the 'guiding light' for tax. /23/ 

 

   Auditing certified public accountants (CPAs), moreover, look at basis accounts with an attitude that does not help the tax system get its tax collected. CPAs have duties to the investing public to prevent puffery and they take the duties seriously enough, at least, to resist some management overstatements. But CPAs have never viewed themselves as having a duty to the IRS. They will not monitor understatement of basis -- maybe because they have never even seen an understatement. CPAs now are especially gun shy, moreover, because of the multi-hundred-million-dollar malpractice settlements they have been paying on claims that they allowed their clients to overstate income. /24/

 

   GAAP, finally, has a number of rules that are nonsense as a matter of economics. GAAP treats future costs with trivial present value detriments as if they were current payments, without discounting the costs to reflect the time value of money. /25/ In the capitalization area, GAAP erroneously assumes that recurring costs need not be capitalized. /26/ The errors of GAAP should not be imported into the tax system.

 

 

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                          II. The Decision in INDOPCO

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   The effect of the INDOPCO future-benefit test extends far beyond the INDOPCO facts, but, at its narrowest, the case holds that when Unilever acquired all of the stock of National Starch in a tax-free acquisition, the professional fees that National Starch incurred were nonamortizable capital expenditures. National Starch became a wholly owned subsidiary of Unilever by reason of the acquisition. While the appeal of the case was pending, Unilever changed the name of the subsidiary from National Starch to INDOPCO. The case is thus known both as the National Starch case, as it started, and as the INDOPCO case, its name in the Supreme Court. 

 

   The holding that the professional fees incurred by a target in a tax-free acquisition may not be deducted immediately was no surprise. It was 'well-established' /27/ before INDOPCO that professional fees incurred by the target in a tax-free acquisition could not be expensed immediately. The Supreme Court holding just continued the well-established rule. None of the judges hearing the case, from trial to Supreme Court, would have allowed the expenses to be deducted immediately, and it is tough to find enough to the contrary even to meet a 'substantial authority' reporting standard. /28/ 

 

   There were, however, a number of other rationales, besides the investment or capitalization rationale, that the Court could have used to deny the immediate deduction, and alternative rationales would have fit the facts more comfortably. On the facts of the case, a court could well have held that expenditures were dividends to shareholders and neither an expense nor an investment at the corporation level. Finding the dividend would have stripped any basis from expenditures at the corporate level, but it also would have prevented the Court from finding a capitalized investment from expenditures that had quite speculative future value at the corporate level. Alternatively, the Court could have treated the fees as costs of a tax-free sale of assets by the corporation and so deferred recognition of the expenses until the assets were ultimately sold. That rationale would have denied  the immediate tax deduction without regard to whether the sale or the fees of the sale had any future value. The fact that the case was argued and settled as a capitalization case means INDOPCO, as it came out, justifies capitalizing costs, possibly forever, on the basis of quite vague future values.

 

 A. The Dividend Alternative 

 

   On the facts of INDOPCO, a court could reasonably have held that the target corporation's expenditures were a dividend to its shareholders. The test for whether a corporate expenditure is a dividend is a 'primary-benefit' test that asks whether the corporation or the shareholders get the primary benefit from the expenditure. A corporate expenditure that 'primarily benefits' shareholders is a nondeductible dividend. /29/ The 'primary-benefit' dividend cases are decidedly not taxpayer-friendly. /30/

 

   The primary-purpose standard sets up a test that would have undoubtedly treated the INDOPCO fees as dividends, if dividend had been argued, because the fees served purposes assigned by the law to the shareholder world and had little plausible relationship to purposes assigned to the corporate level. Fees in the amount of $2.2 million went to the investment banking firm of Morgan Stanley and, at that level of magnitude, the fees are best understood as broker's commissions related to bickering over the purchase price to be paid to the shareholders for their stock. Investment bankers do not, in general, do billable hours; they dip into large streams of money going by. Morgan Stanley was paid by the target corporation, but the primary value of its services came from its suggestion to Unilever, the acquiring corporation, that it should sweeten the offer to the target shareholders. The suggestion was so successful that the Unilever offer went up by $23 million to $483 million, which explains a good deal of why the target was willing to pay a $2.2 million fee. 

 

   Fees of a mere half million dollars went to the New York law firm of Debevoise Plimpton as compensation for billable hours spent, among other things, creating an innovative -- even unprecedented -- transaction to get nonrecognition of taxable gain for the target's major shareholder, while giving most shareholders cash. On a stock purchase, the tax-free treatment to the corporation was never in doubt. Bickering over the price of stock and achieving tax-free treatment for the shareholders are ownership issues, assigned by the tax law to the world of the shareholders. They are not related to corporate operations nor matched with any corporate taxable income. 

 

   The benefits of the transaction on the target corporate level, on the other hand, were ephemeral at best. There was no taxable income or income from operations that the fees contributed to or could be matched with. The fees effected a transfer of stock -- a shareholder- or ownership-level concern -- and had no effect on corporate operations. The target's costs were justified in the real world by the benefits the reorganization gave at the shareholder level, not at corporate level. 

 

   The taxpayer's brief argued, quite eloquently, that there was no significant benefit to the operations of the target corporation: 

 

   National Starch was itself unchanged by the transaction -- it 

 

   did not sell or otherwise dispose of any stock or assets, nor 

 

   did it acquire any stock or assets. All that happened was that 

 

   its existing stockholders disposed of their stock. . . . After 

 

   then transaction, National Starch's management (its directors and 

 

   officers) remained in place, its key employees entered into 

 

   employment contracts with the company, and its business 

 

   (adhesives, starches, and specialty chemical products) continued 

 

   in the same way as before. Unilever did not make any changes in

 

   National Starch's operations, did not provide [National Starch] 

 

   with any significant technological or financial assistance or 

 

   legal, administrative or accounting services and did not 

 

   materially increase its purchases of National Starch products. 

 

   /31/ 

 

   The taxpayer was arguing so vigorously because it was trying to avoid capitalization by arguing that there was no future value for the fees, but the current values to the corporation from the reorganization were not any greater. All of the plausible benefits from the transaction lay in the future. By denying future value, the taxpayer was also denying, against interest, that there was any corporate-level benefit at all. 

 

   As a matter of accounting theory, moreover, the target corporation is not even involved in a transaction in which basis carries over. In a purchase of another corporation, the acquiring corporation is required to increase the basis of the assets acquired to the level of the purchase price, which increases the acquiring corporation's subsequently reported depreciation expenses. 'Poolings,' however, are the accounting equivalent of a tax-free reorganization and in a 'pooling,' the acquiring corporation carries over the target's accounts and thus avoids the step-up in subsequent depreciation expenses. The rationale, under accounting theory, for avoiding the increased depreciation is that poolings are transactions solely among the two shareholder groups and neither the acquiring nor the target corporation is involved. /32/ Applying accounting theory  to tax-free reorganizations would mean that the corporations were not involved and that the costs of reorganizations benefit shareholders alone, as a matter of law, whenever the acquisition is a tax-free acquisition. The fees then would be dividends, under the primary- purpose test, as a matter of law since the corporation level was not involved and only the shareholder level received a benefit. The IRS did not argue dividend in INDOPCO, once the case got out of the Tax Court, but it has a pretty good argument, available for any future case, that the target's professional fees in a reorganization are always dividends. /33/ 

 

   Dividend treatment would have been even worse for the taxpayer in the case than the capitalization treatment the taxpayer suffered. As a dividend, the $2.7 million fees would have created neither an immediate deduction nor basis at the corporation level and the shareholders would have had $2.7 million of dividend income they avoided as the case came out. The taxpayers in INDOPCO got off lightly. Still, the fact that the case was not argued as a dividend case was not necessarily good news for taxpayer interests in general. The judges were not going to give the taxpayer an immediate $2.7 million expense deduction for fees that felt like a dividend. The Supreme Court, in any event, bought the government's surviving argument that the expenditures were capital expenditures, finding the $2.7 million gave 'significant benefits beyond tax year.' On the facts, the corporate-level benefits were quite modest. The target did remain a separate subsidiary without change in management, technology, financing, market, or operations and the 'synergism' the Court pointed to might not have existed.

 

 B. The Matching Alternative

 

   If capitalization had never been raised, the taxpayer still would have lost its immediate deduction on the ground that costs of tax-exempt or tax-deferred sales may not be deducted currently. By the reorganization, the target accomplished a deferred-gain sale of its assets. The gain built in to target assets was not taxed in the acquisition, but carried over to the acquirer with the carryover of the target's basis until the assets were sold in a tax-recognized sale. /34/ Matching would require that the costs of accomplishing a deferred-gain sale cannot be recognized until the gain from the sale is recognized. Under modern accounting theory, it is a sin, the sin of mismatching, to deduct expenses immediately, while deferring the gain on the sale. /35/ If the Court had heard and bought the matching theory, it would not have mattered if we view the sale or its costs as having a future value or creating a separate asset. Since the gain is deferred, so are the related expenses, even if the sale and the expenses created no real-world future value. 

 

   The matching alternative would have been a better rationale for taxpayer interests. The taxpayer still would have lost its $2.7 million immediate deduction under the matching or deferred-gain rationale, just as it lost its deduction under the capitalization rationale, but the case also would have had no impact on capitalization decisions outside of the area of nonrecognition sales. The deferred gain theory also would have given the acquiring corporation a better chance of recovering its $2.7 million costs, before the time when the Unilever group as a whole was liquidated. 

 

   The capitalization theory the Supreme Court adopted means that the Unilever group, the acquirer of National Starch, would have a $2.7 million basis to be used at some point. By reason of the capitalization, National Starch, which paid the fees, would have a $2.7 million basis account. A target's basis in assets does not produce tax deductions or tax losses in the reorganization, but the basis was carried over to the acquirer (Unilever) group, when National Starch became a Unilever subsidiary. /36/ Liquidation of the target after it became an affiliated subsidiary would not justify a tax deduction or tax loss for the expenses either, /37/ but the basis then would become basis of the surviving parent corporation. /38/ When would the acquiring Unilever group recover the $2.7 million basis? 

 

   The Supreme Court seems to have adopted the position that the $2.7 million costs may be deducted only when the entire Unilever group goes out of business. There is a traditional argument, cited favorably by the Court, that the costs of a tax-free acquisitive reorganization acquire an improved corporate structure. The improved structure is treated as having continuing value until the whole acquirer group is liquidated. /39/ The costs thus would be recognized only at the final liquidation of the whole Unilever group, which may be a ways off. 

 

   By contrast, a matching or deferred-gain theory would have allowed the Unilever group to recognize the costs as it recognized the gain on the acquired assets. Unilever should preserve its basis in the acquired business as long as the business has continuing value as an investment, so that its aggregate basis should not drop below the aggregate value of the business.  At a minimum, under this rationale, however, Unilever would have been able to use all of the $2.7 million basis when it lost, sold, or abandoned its investment in the National Starch business or broke up the investment into separate assets, even if the whole group was not liquidated. /40/

 

   On the merits, the Supreme Court's improved-corporate-structure theory is not all that plausible. The $2.2 million fees to target's investment banker, for instance, were hostile to Unilever in wrangling over price. Morgan Stanley was trying to increase the price Unilever had to pay. Thus, it is hard to see how the Unilever group got any benefit out of the fees, much less a permanent structural improvement. The target-side fees were either dividends to target shareholders or they were costs of the target selling its assets, but they were not investments (capital expenditures) that produced continuing income for Unilever. Permanent basis is a fine result for permanent investments, including such things as corporate structure, but these fees were never any help to Unilever, much less a permanent help. Treating the fees as deferred expenses to be matched against deferred gain would have a more plausible result and also less adverse to taxpayer.

 

 C. The Separate and Distinct Asset Argument 

 

   The taxpayer's primary argument in INDOPCO was that the $2.7 million fees could not be capitalized because they did not create a 'separate and distinct asset.' Every judge rejected the argument /41/ -- rightly in my view. It is not clear under taxpayer's theory what characteristics an 'asset' was supposed to have, but the taxpayer seems to have assumed that an 'asset' test was a strict test, preventing the capitalization of costs that concededly had significant value. That usage of the term, 'asset,' does not make any sense as a matter of accounting theory or terminology: In accounting, the label, 'asset,' is not a statement of fact, but a conclusion. 'Asset' is synonymous within nontax accounting with the tax term, 'basis.' An 'asset' occurs because the taxpayer has incurred a business-related cost and has not yet recognized the cost. Putting an 'asset' on the balance sheet is the mechanism by which a cost is carried over to be recognized in future years. Profit-related costs need to be recognized at some point, so that if an expenditure has not been deducted yet, then, of course, the cost is capitalized and creates an 'asset' to be recognized at some point in the future. In tax accounting, the term is 'basis' rather than 'asset,' but the underlying meaning is the same. If a business cost is capitalized, then of course it creates basis ('asset'). Still, the requirement that there be 'basis' ('asset') is no barrier or bar to capitalization. If you need an asset, all you need to do is say 'Poof, you're an asset' and the requirement is met. As a result of losing its capitalization case, INDOPCO had an asset (basis). 'Asset' is not a prerequisite to capitalization; it is a result of capitalization. 

 

   Under accounting theory, moreover, an asset test and a 'future- value' test are not competing tests, but one and the same test. Accountants treat expenditures as assets on the balance sheet because the costs will produce future revenue. Capitalization merely carries the costs forward, via the balance sheet, to be matched with and offset the future revenue. Costs such as prepaid rent, interest, or salary are assets because they cause future income even though the costs have no salvageable or transferable value. The significant 'future-value' test the Court adopted comes from accounting theory defining what an asset is. 

 

   In INDOPCO, the Supreme Court held that the existence of an asset is sufficient, but not necessary for capitalization. /42/ By its use of the term, the Court also seems to have thought that 'asset' refers to something out there, albeit not necessarily a tangible thing. The merit of the decision is not in a better definition of 'asset' than taxpayer offered, but rather in that 'asset,' whatever it is, is not a requirement. /43/ 

 

   Given the arguments before it, the Supreme Court acted responsibly in finding the $2.7 million expenditures to be capital expenditures. The Court threw out an artificial 'separate and distinct' asset rule, that might have proved a barrier to good accounting. It tried, with its energy, to make tax accounting describe the taxpayer. Both the dividend and the deferred sale arguments are better rationales to deny the taxpayer its deduction because they fit the facts more aptly, but neither the taxpayer nor the government raised the arguments. The government went forward, conservatively, relying on the capitalization argument that had convinced the Tax Court, among the alternative arguments raised, and the taxpayer did not want to raise arguments that would undermine its primary goal. The  Supreme Court sometimes decides cases on grounds not raised by the parties, but rarely in tax cases, where it does not have all that much self-confidence. There are those that argue, indeed, that the Court should never go beyond the arguments raised by the parties because that would be like dicta or advisory opinions. The immediate deduction had to be denied. The capitalization argument was at hand and served the need. Who can blame the Court for adopting it? 

 

   Counsel for the taxpayers swung for the fences with their argument, trying to get expensing for reorganization costs that had never been expensible before and for costs that were reasonably treated as dividends. Having swung hard and missed, INDOPCO counsel created an important, taxpayer-adverse capital expenditure precedent. Supreme Court cases, once decided, have a penumbra that affects many, many subsequent cases.

 

 D. INDOPCO Fees Under New Section 197 

 

   Congress, in 1993, provided that intangibles acquired in a purchase of a business could be amortized over 15 years, but it specifically excluded INDOPCO fees from the benefits. Paragraph 197(e)(8) of the new section excludes professional fees in a tax-free reorganization from the definition of the 'section 197 assets' that are eligible for amortization over 15 years. /44/ 

 

   The INDOPCO fees fit none of the purposes for which 15-year amortization was enacted. Section 197 was not enacted to be an accurate description of how long business goodwill and other such assets last. /45/ It was a compromise provision, enacted to end wasteful litigation over what was the tax life for the various assets acquired in a taxable purchase of a corporation and over what proportion of an overall purchase price would be allocated to the various short-lived and long-lived assets. /46/ For INDOPCO professional fees, neither allocation nor tax life was an unsettled issue. The $2.7 million INDOPCO fees went to separate, third-party professionals, so that no lump sum purchase price needed to be allocated. In the INDOPCO case itself, the Supreme Court seems to have told us the life of the fees: they last indefinitely until the Unilever group liquidates. There was thus no unfinished controversies that needed to be settled. 

 

   Section 197 was also enacted to cut back on the 1986 reforms, repealing the General Utilities rule, so that taxable purchases would be cheaper. /47/ The INDOPCO transaction, however, was a tax-free- reorganization, a purchase that already bore zero tax. Allowing amortization of the costs of a tax-free sale would mismatch tax- deductible costs and tax-exempt gain. Deducting costs of tax-free sales would mean the tax burden on the net sale gain would be less than zero. 

 

   Finally, the INDOPCO fees are properly understood as dividends, either as a matter of law or under the facts. Dividends should neither be deducted nor amortized at the corporate level. /48/

 

 E. Other Takeovers 

 

   1. Hostile tax-free acquisitions. The bar has expressed concern that INDOPCO might be 'stretched' beyond friendly takeovers. /49/ If a tax-free acquisition goes through, however, it is difficult to see any meaningful distinction between a takeover like INDOPCO's and a takeover that started as hostile to the target's management. To shareholders, the major difference between a hostile and a friendly takeover is price. Hostile takeovers are those in which the price is too low and friendly takeovers are those in which the price is high enough. In the recent Tax Court case of Victory Markets, Inc. v. Commissioner, /50/ for instance, which also capitalized the target's costs, the acquirer's offer was considered hostile at $30 a share, but it became quite friendly at $37 a share. If the takeover is successful, we should ignore management arguments that business was hurt rather than helped by the takeover. The success of the acquisition means shareholders thought the takeover  was better than continuing with existing management. If a little hostility could distinguish INDOPCO and win the advantage of expensing, in any event, then parties undoubtedly would start acting like professional TV wrestlers and snarl at each other for the cameras. 

 

   As a matter of tax theory, in any event, if a tax-free acquisition goes through, the transaction is still a tax-free sale. It is the sin of mismatching to deduct sale expenses while deferring the gain on the sale, no matter how the transaction arose. /51/ 

 

   2. Taxable takeovers. INDOPCO was a tax-free sale, but if the purchase is taxable to the target corporation, the expenses of the sale should be recognized as an offset to the sales proceeds. Taxable gain acts like a magnet, pulling in expenses of the sale as an offset to the gain. /52/ Similarly, if target makes a now-not-very- common election under section 338 to treat a stock sale as if it were a taxable asset sale, the target should be able to use its expenses against taxable asset gain. The old management of the target, as a matter of economics, would not necessarily know when it made the expenditures, whether a section 338 election would be made. Nonetheless, viewed with a goal of achieving matching, the expenditures should be recognized when and if the gain on the assets is recognized. 

 

   Also, if the target's sale is taxable, the sale expenses should not be a dividend. Taxable gain at the corporate level is a corporate-world factor and a sufficient reason to treat the corporation's expenses as justified primarily by the benefit to the corporation. As long as we tax the corporation apart from the shareholders, it seems quite reasonable to allow the corporation a deduction for its necessary costs of achieving that taxable gain. Thus, it does not matter if, in fact, the sale of assets were motivated, even primarily motivated, by shareholder gain; the corporate-level tax gain is sufficient to justify corporate-level recognition of the costs. 

 

   3. Abandoned takeovers. The target's cost in connection with acquisition that fails to go through is a lost cost. The cost needs to be deducted because it is no longer an investment. In the bankruptcy case of In re Federated Department Stores, Inc., /53/ for example, the court allowed an immediate deduction for a 'break-up fee' paid by target pursuant to a prior contract arrangement after its proposed acquisition failed to go through. The break-up fee had no long-term benefit since the transaction failed. More generally, if the transaction costs are not investments producing income in the future, they should be deducted as they expire. If the transactions fail and the shareholders end up with the same stock and management they started with, for instance, it is difficult to see how they can be said to have made an income-producing investment. 

 

   Some fees and other transaction costs will be capitalized, however, because they are part of a bigger, overall plan. In Letter Ruling 9402004, for instance, the taxpayer corporation incurred significant legal, financial, accounting, and other transaction costs looking for a buyer for the corporation when its major shareholders were ready to retire. The taxpayer sought to deduct six-sevenths of the transaction costs as abandonment losses, arguing that merger was consummated with only one of the seven serious suitors for the corporation and the rest were left abandoned. The Service responded, quite appropriately in the circumstances, that all seven flirtations were part of a single effort to sell that corporation and that nothing was abandoned. /54/ 

 

   A common pattern for takeovers in the 1980s was that a target that repelled the first shark would thereafter immediately become 'in play.' The target soon would be taken over by another shark or by a 'white knight' recruited by target management. All of the 'shark- repellent' costs of an in-play company are plausibly related to the final, successful takeover. The costs are part of one big plan to increase the sale price to shareholders. If so, the costs should be capitalized, as part of the finally successful transaction.

 

 

________________________________________________________________________________

 

                III. Broader Application of Future Benefit Test

________________________________________________________________________________

 

   INDOPCO's 'significant-future-benefit' test applies to capitalization decisions in the areas of prepaid fees, business expansion costs, repairs, and environmental costs. The test can be expected to clarify and improve the law and to overturn some erroneously decided cases.

 

 A. Prepaid Fees /55/ 

 

   As a matter of accounting and economic theory, prepaid expenses are investments and capital expenditures. /56/ Prepaid expenses need to be capitalized because  they provide significant future benefit. /57/ Economics mandates putting the costs in basis because they produce future income. Good accounting theory puts prepaid expenses on the balance sheet to be carried over to future years. Nonaccountant judges have sometimes erred on the issue, saying that expenses are different from capital even if they are prepaid. /58/ In accounting theory, however, a prepaid expense is just another kind of capital expenditure. Accounting capitalizes expenditures not because they have some permanent, special 'capital' status, but because they relate to future income. All accounting assets are just past costs stored in the balance sheet 'warehouse,' to be matched with some future income. Accounting assets can be highly intangible. 

 

   There are a number of cases, however, that use bogus 'immateriality' rules and allow expensing of prepaid expense under quite strange standards of materiality. Those cases were strange when decided -- the courts seem to have misunderstood the importance of capitalization. The cases now are questionable in light of INDOPCO and seem destined to be overturned. Small costs not worth accounting for can be tolerably expensed, but expensing is not allowed after INDOPCO for costs that give significant future value. Immaterial costs that can be expensed are those that would not be worth the effort involved in accounting for them. Material costs with significant future benefits are capital expenditures. 

 

   There is, for instance, a one-year or Zaninovich rule in the Ninth Circuit that allows a cash-method taxpayer to deduct next year's expenses this year, even when the investments are significant. In Zaninovich v. Commissioner, /59/ the court held that 11 months of prepaid rent could be deducted by a cash-method taxpayer when paid because expensing had 'ease of application' and capitalization was 'an inconsequential change in the timing of deductions.' /60/ The court seems to have been ignorant of the advantages of soft-money investing. 

 

   The Zaninovich rule was wrong from the outset for significant costs, and it should not survive INDOPCO. Even one-year investments should be capitalized if they are significant. There is no good policy reason to give a zero effective tax rate to significant, albeit short-term, investments. There is, in fact, no improvement in administrative ease in allowing next year's expenses to be deducted this year. Some line must still be drawn between expensible and capitalized investments and it is easier to draw the line earlier rather than later. It is tougher to figure whether costs will have value a year away than it is to figure their value at the end of the year in question. /61/ If one-year costs are significant, worth the effort of accounting for them, then INDOPCO can be expected to capitalize them. 

 

   The Tax Court has rejected Zaninovich on the ground that it is not appropriate to allow next year's expenses to be deducted this year, /62/ but it has its own rule for prepayments that also tolerates the expensing of significant costs. The Tax Court rule is that a nonrefundable prepayment of product costs may be expensed by a cash-method taxpayer if the prepayment was nonrefundable when paid and if the fact of the prepayment was negotiated between the taxpayer and the recipient of the prepayment. The Tax Court presumes that there was a nontax business purpose that legitimates the prepayment, if the taxpayer had a chance to bargain with the recipient. /63/ Expensing has even been allowed, under the Tax Court rule, for very large, one-time-only syndicated tax shelters. In Haynes v. Commissioner, /64/ for instance, a syndicated tax-shelter partnership bought $7.3 million worth of feed in late December, little of which was used by year end. The Tax Court allowed expensing of the $7.3 million investment, notwithstanding its manifest materiality. 

 

   The Tax Court's generosity toward prepayments was bad law when decided and cannot be expected to survive INDOPCO. A taxpayer has a business purpose in making investments that is at least as strong as his  or her business purpose in paying expired expenses, so the fact of business motive, even if presumed as a matter of law, does nothing to distinguish expired expenses, which can be deducted as tax losses, from investments with significant future benefits. Congress has shown considerable hostility to the syndicated shelters that exploit prepayments allowed by the Tax Court rule. /65/ Deductions of prepayments are always abuses, if significant. Prepayments are investments by definition, producing only future benefits. There is no reason why the profit produced by buying product costs early should bear zero effective tax rate. Prepayments will undoubtedly prove to be capitalized by INDOPCO when they are significant.

 

 B. Business Expansion Costs 

 

   INDOPCO can be expected to require greater capitalization of business expansion costs than is allowed by the current case law, in part because it revives an excellent decision of Judge Murnaghan of the Fourth Circuit. In NCNB Corp. v. United States, /66/ a panel of the Fourth Circuit in an opinion by Judge Murnaghan held that a bank, NCNB, had to capitalize its costs of expansion under good accounting theory. NCNB did 'Metro studies' about the economic possibilities in alternative cities it was considering and 'feasibility studies' focusing on specific locations. The panel decision held that costs were capital expenditures. The panel remanded the case for a determination of useful life. In accord with the panel decision in NCNB is Central Texas S&L v. United States, /67/ in which the Fifth Circuit held that the costs of getting regulatory permission to open a branch office was as much a part of the bank's assets as were the bricks and mortar of the branch. The NCNB panel avoided the hard issue of determining when the Metro and feasibility costs were recovered, by remanding the case. Arguably, costs last as long as the bank has a presence, just as a liquor license is valuable as long as the liquor store remains open. Permanent basis is, of course, a fine rule for a permanent investment. 

 

   In NCNB (en banc), /68/ however, the full Fourth Circuit en banc reversed the panel and allowed NCNB to deduct the costs of its studies immediately. The ground of the court's reversal, however, was that the court was under the misapprehension that the costs could not be capitalized because they did not create a 'separate and distinct asset.' NCNB (en banc) was on the wrong side of the conflict between the circuits in the INDOPCO certiorari petition. Thus, NCNB (en banc) now seems to be questionable at best, foreordained to be overruled. The well-reasoned panel decision in NCNB is the best judicial discussion I have seen of the role of accounting theory in tax. Under INDOPCO, NCNB I (panel) is restored as good law. 

 

   One commentary on INDOPCO has argued that business expansion investments may be expensed because of the enactment of section 195. Section 195 provides that business 'start-up expenditures' may be amortized over five years once the business starts. Start-up expenditures are defined as the costs of investigating, acquiring or creating a business, and the ordinary, periodic business-motivated expenses that are incurred before business activities start. /69/ George Javaras and Todd Maynes argue that section 195 creates a 'congressional mandate,' as they put it, to expense business expansion costs immediately when incurred. /70/ 

 

   The argument, however, is frivolous. Section 195, on its face, trumps nothing. The language of section 195 says that its five-year amortization treatment applies only to expenditures that would be current deductions if incurred by an ongoing business. /71/ Once an expenditure is capitalized, whether by INDOPCO or otherwise, section 195 politely stands aside. Section 195 was also aimed at a very different problem than the NCNB business expansion problem, which was the travesty of an investor whose profit-motivated, pre-opening expenses would be treated as personal costs, never creating basis and never recognized for tax. /72/ Because it is already in business, NCNB does not have the personal-cost problem that section 197 was enacted to remedy. If section 197 did apply, moreover, it would not give an immediate deduction -- which is what Javaras and Maynes want -- but rather a deferred deduction over no less than five years. 'Congressional mandate' is a pretty heavy term for an argument that has so little support in the language or purpose of the statute.

 

 C. Remedial Costs 

 

   Repairs and other remedial costs are no different from any other costs. They should prove to be capitalized  under INDOPCO if they provide significant future benefits. Deductible repairs are those repairs that have expired by year-end or that can be treated as if they had expired without material distortion. 

 

   Remedial costs arise when a taxpayer has both a prior loss and the cost that is needed to fix it. In the analysis of the situation, however, the prior loss and the new cost must be kept separate. The precipitating loss and the remedial costs must be analyzed step by step. 

 

   1. Step One: Loss of old costs. A remedial cost is triggered by some precipitating event such as an accident, threat, or change in circumstances. Sometimes the precipitating event yields a tax deduction. When, for instance, a business asset is destroyed, its remaining basis expires and the regulations allow the remaining basis to be deducted. /73/ Sometimes, however, the precipitating event does not generate a tax loss. The taxpayer may have zero or trivial basis or the loss may just reduce unrealized appreciation. Or the loss may be unrealized, or a foreign loss, or a passive loss, or a personal loss too small to get over the section 165(h)(2) hurdle (10 percent of adjusted gross income). Thus, the precipitating loss commonly generates a tax deduction that is smaller than the remedial costs needed to repair it. The allowable deduction from the precipitating loss is then smaller than the new cost. 

 

   2. Step Two: New cost. A remedial cost is a new expenditure, albeit triggered by the loss. The remedial cost may or may not have significant future value. If it has significant value for the future, it needs to be capitalized. Incidental (small) repairs may, however, be expensed because they are not worth the effort involved in keeping track of them. The regulations provide that 'the cost of incidental repairs which neither materially add to the value of the property nor appreciably prolong its life' may be deducted. /74/ The materiality rule means that, in practice, tax accounting has protaxpayer departures from good theory that are in the nature of rounding errors. A cost also will be an expense, as a matter of good theory, if it expires by year end. An expense in accounting is nothing but a capital expenditure that has expired by year end. 

 

   A remedial cost does not necessarily attach to the old asset. Paying a remedial cost is a separate investment decision. The cost can have its own tax life, for instance, when it causes income for a period shorter than the life of asset it repairs. /75/ The basis and life of the new cost should be separated from the basis of the old asset, just as remedial costs are separated from the old loss. 

 

   3. Conflating the steps. Deduction of the old cost sometimes will happen to offset capitalization of the new expenditure. /76/ But step one, loss of old costs, should not be presumed to offset step two, expenditure of new costs. If there are good and binding reasons why the precipitating loss does not generate a tax deduction directly, the loss should not generate a tax deduction indirectly in making an otherwise good investment, suddenly deductible. Conflating the transaction into a single event is a mistake that sometimes would lead to deduction of new costs that have not been lost. In many of the cases, the taxpayer has already deducted the old costs without challenge and is seeking to deduct the new costs too. Deduction of a new investment that has not been lost is a sin in tax accounting if it leads to an adjusted basis that is lower than the continuing investment value. 

 

   The error of conflating the precipitating loss of an old cost and the new remedial expenditure is akin to the error with respect to 'interest-free loans' that was corrected by the enactment of section 7872 of the code. Section 7872 treats an interest-free loan as involving a payment of interest, as the clock ticks, and an equal and offsetting payment in the opposite direction. Section 7872 mandates that the interest payment and its offset must be analyzed separately. The interest, carved out by section 7872, sometimes is deductible and sometimes not. The reimbursement identified by section 7872 sometimes will be income and sometimes not. Prior to the enactment of section 7872 there was a presumption that interest and its reimbursement would be offsetting. /77/ Section 7872 requires that we check the offsetting nature of the tax treatment. Similarly in the repair area, we need to separate the loss and the costs spent to repair the loss to check whether the loss and the repair are separately deductible. 

 

   Allowing costs to be expensed because they are repairs or remedial costs leads to a fallacy that might be called the 'sunk- barge fallacy.' The sunk-barge fallacy can lead to the expensing of what are perfectly fine investments. The sunk-barge fallacy leads to a deduction indirectly that would never be allowed if the deduction were considered alone. 

 

   Assume, for instance, the taxpayer has a barge that sinks. /78/ The undepreciated cost of the sunken barge is  $750. The $750 cost has expired and needs to be written off. The cost of that barge is a sunk and expired cost. Under the regulations, the taxpayer has a $750 tax loss. /79/ 

 

   Assume that new barges cost $100,000 each and that many businesses are investing in such new barges this year. Everybody who buys the new barge knows it is a capital expenditure. Assume also that it would cost $110,000 to raise the sunken barge, over and above mandatory clean-up. The $110,000 cost would give a barge almost as good as the new one. Thus, the $110,000 cost has a significant benefit beyond the taxable year. The raising costs and the new barge compete with each other as investments. In absence of tax, an investor would buy the new barge because that is a better investment. If both investments are capitalized, tax will not distort the investment decision. 

 

   If remedial costs may be expensed, however, as one strain of our case law allows, /80/ then tax will distort the investment decision. The $110,000 expensed investment will be the better one after tax. Income from the new barge would be taxed, presumably at statutory rates. But income from the $110,000 investment to raise the barge would bear an effective tax rate of zero. Deducting a $110,000 investment that remains intact is bad accounting that will cause bad investments. 

 

   It is an error of some proportion to allow the precipitating loss to justify the expensing of a significant new investment. The precipitant loss is a small loss for tax purposes, a modest $750 deduction under any defensible tax accounting. But, if the remedial costs become expensible, the small $750 loss will determine the tax treatment of a significant $110,000 investment. A small $750 tail will wag a $110,000 dog. 

 

   There is a line of authority under current law that does allow remedial costs to be expensed, so long as they do not improve the taxpayer's position measured at a time before the precipitant loss. /81/ The cases, in essence, look to see whether the condition of the barge is improved as compared with its condition before the precipitating event, i.e., from its prior position at sea level. 

 

   Many of the cases that judge 'improvement' from the prior sea level are absurd cases, allowing expensing of perfectly fine investments. In 1876, for example, in Grant v. Hartford & N.H.R.R. /82/ the Supreme Court allowed a railroad to expense the cost of a new railroad bridge because the replacement bridge was required to keep the railroad running. On that logic, I suppose that any multimillion-dollar bridge can be expensed, so long as there was something there before that the bridge can be said to replace. In United States v. Times-Mirror Co., /83/ the court allowed a Los Angeles newspaper to expense the cost of microfilming its morgue of old newspapers -- said to be occasioned by threat of Chinese Communist bombing of Los Angeles during the Korean War. Microfilming records now looks like a wise investment, whether or not there was a Chi-Com threat to L.A. 

 

   The INDOPCO significant-benefit test will overrule the sea-level line of cases, in part because they were wrong before INDOPCO on their economic merits. Under an income tax that provides a level playing field, investments with continuing value should not be expensed. 

 

   INDOPCO strengthens a competing line of cases that says the 'improvement' nature of a cost must be judged from the condition of the barge at sea bottom. /84/ This sea-bottom line of cases is stronger than the sea-top cases in number and in logic. Irrespective of the particular occasion that necessitated the improvement, so this line holds, a cost should be capitalized if it gives significant value beyond the taxable year. /85/ INDOPCO reinforces the wisdom of this line. 

 

   4. Repairs and the prime directive. The sea-level cases that measure the improvement from before the accident also usually allow the taxpayer's basis to drop below the value of the taxpayer's real income-producing investment. When that happens, the real or effective rate of tax is lower than the statutory norms. Sometimes the cases allow the taxpayer to have his or her cake and eat it too. The taxpayer comes to court having already claimed a deduction because of the precipitating loss, so the only issue is whether a deduction also should be allowed for the remedial expense. A deduction for the remedial cost is not a double deduction. The original cost, now expired, and the remedial cost are both expenditures. The taxpayer will need to be allowed recovery of both costs at some time. Still, if the accident is justifying the deduction of both the original now- expired cost and its replacement, the taxpayer's basis will fall below the real income-producing investment value. 

 

   It is also possible for the 'sea bottom' cases to produce a basis that is higher than the investment value of the asset at the end of the transactions. If the old cost is not deductible because it is unrealized, or for some other reason, the cumulative basis from old and new cost may be larger than the investment value of the asset when the transactions are over. Notwithstanding the prime directive, however, the high cumulative basis sometimes is justified by the principle of 'nonrealization' or some other tax policy that restricted recognition of the old loss. If the precipitating loss is not allowed, when the law focuses its attention on the loss, it should not be allowed by indirection via the expensing of a perfectly fine replacement investment. If, for instance, the loss is a capital loss or a foreign loss restricted as to tax use by the separate schedules for those losses, the replacement investment should not be expensed where it has future value. 

 

   If the lost property just had a zero basis, we have some assurance that the basis will not exceed the investment value of the asset. Investors do not repair assets unless the asset they end up with is worth more than the cost. From the fact the investor made the repair, we comfortably presume that the asset was worth more than the repair and hence we can fairly capitalize the repair. 

 

   5. Invalid arguments. There are in the literature a number of invalid arguments that are said to justify expensing of remedial costs and other investments. It is said, for instance, that recurring costs need not be capitalized because they can be expensed without significant harm. It is also said that remedial costs are deferred maintenance costs and that they can be deducted immediately because they are in the nature of prior period adjustments. Neither argument, in my opinion, survives INDOPCO. 

 

   a. Recurring expenditures. Some commentators have argued that investments may be expensed when made if they are recurring. After some transition period, the argument goes, the net income from a steady stream of investments will be the same, whether investments are deducted when made or only as they expire. /86/ The argument originates from the GAAP fundamental convention of 'consistency': If they are consistently applied, even erroneous accounting methods give useful information for GAAP purposes because they report changes over time. 

 

   The argument that expensing of recurring investments makes no difference, however, is a mistake for tax. Hard-money and soft-money investments are not the same, even after time. As argued, the capital invested in a soft-money (expensible) investment will be 1/(1-t) bigger than a hard-money investment, where t is the tax rate, for the same after-tax burden. Under a 50-percent tax rate, the firm that expenses its investments will be twice as big as the firm that capitalizes its investments, even after the transition period. Under a 33-percent tax rate, the firm investing soft money will be 150 percent of the size of the firm investing hard money, even after time. Soft money investing is like exemption of the subsequent returns, even for recurring investments. Expensing of recurring investments is not a trivial error even after some time. /87/ Consistency does not work in judging tax capitalization because it does not take account of the normal tax that reduces the base amount of capital when the capital was invested. 

 

   6. Deferred Maintenance? The Tax Executives Institute (TEI) has submitted comments to the IRS arguing for the expensing of the costs of cleaning up asbestos from taxpayer's buildings, on the ground that the clean-up cost is just 'deferred maintenance,' that is, just catching up with clean-up the taxpayer should have done earlier. The TEI argues that since the repairs would have been deductible if made when due, they should be deductible repairs even if deferred. /88/ It is not clear what 'due' means in the argument, but let us assume, arguendo, that all asbestos should have been cleaned up before now.

 

    The costs of cleaning up asbestos are in fact forward-looking investments, related to future rather than past revenue. The purpose of a clean-up is to make possible continued human occupation of the building that had the asbestos. The clean-up will have value so long as the building has value. Today's clean-up produced no revenue in the past, in part for the obvious reason that causes only go forward in time, not backward. The costs relate to future income. 

 

   The only meaningful question to ask is whether the clean-up costs will have expired by year-end. The damage to the building done by the asbestos is a sunk cost. It is a mistake, a sunken-barge fallacy, to let sunk or precipitating costs confuse the treatment of new investments. Removing asbestos is the occasion to deduct any remaining basis in the asbestos pipe linings or other insulation, if the old costs have not already been deducted, but it is most likely that the loss has long since been accounted for over the tax life of the lining. /89/ It is a mistake to use long-since-deducted costs as an excuse to deduct unexpired costs. 

 

   If the clean-up costs had been incurred when they 'should' have been, they would have expired by now and long since been deducted. But it is impossible to move back in time and make the expenses happen then, so that they are expired now. If the costs have not expired by the current year, they are capital expenditures even if they would have expired had they been made 30 years earlier. Tax law must be concerned with what did happen rather than with what might have happened 

 

   If the expenses were truly 'prior-period adjustments' that should have been taken in prior years, that does not support an argument that they must now be deducted. For GAAP accounting, 'prior- period adjustments' are charged directly to surplus (accumulated earnings) without ever showing up on an income statement. /90/ Similarly, for tax purposes, expenses that were really incurred in years cannot be shifted forward by election. Expenses now barred by the statute of limitations, for instance, do not resurrect themselves as deductions in the current year. They are lost and will never show up on an income statement, just as prior-period adjustments never show up on a nontax income statement. Since the GAAP and tax treatment of prior expenses imply that the clean-up expenses never show up in the computation of income, there are defects in the prior- period adjustment argument. 

 

   Every remedial cost, moreover, can be characterized as in lieu of prior prevention because 'an ounce of prevention is worth a pound of cure,' because 'penny wise is pound foolish,' and because 'a stitch in time saves nine.' If only we could have foreseen Mrs. O'Leary's cow, then we could have prevented the Great Chicago Fire and saved considerable expense. Nonetheless, rebuilding Chicago was an investment, even though the rebuilding was just in lieu of prior prevention.

 

 D. Environmental Costs 

 

   Environmental costs are a subset of remedial expenses. Some are expired costs when made and some are capital expenditures. After INDOPCO, the tax treatment of the second step, the new cost, should be viewed as a separate matter from the tax treatment of the first step, the loss of the old costs. Environmental investments are helpful to society, but so are many other investments. Nonetheless, the merit of environmental investments does not justify bad tax accounting.

 

   1. Examples of expired costs. Many environmental clean-up costs are expensed immediately because they give the taxpayer no continuing investment. 

 

   a. Oil spills. Assume, for instance, that Oil Co. A was 

 

   liable for all costs of clean-up of Alaska's Prince William 

 

   Sound after a major oil spill. /91/ The costs were not an 

 

   investment to Oil Co. A, but an expired cost. The cost should be 

 

   deducted currently. 

 

   b. Abandoned strip mine. State law increasingly requires 

 

   strip miners to clean up a site when strip mining is complete. 

 

   The cost is not recognized until economic performance occurs, 

 

   that is, until resources are committed to the clean-up. /92/ 

 

   Because all of the revenue from the site has ceased when clean- 

 

   up occurs, however, the clean-up costs are expired and expensed 

 

   when made. Note that the modest rents from the subsequent use of 

 

   a barely rehabilitated site do not justify capitalization of the 

 

   massive clean-up costs because the basis of the site then would 

 

   be disproportionately higher than the value of the investment. 

 

   The fundamental economic norm in capitalization is that basis 

 

   should equal investment value, not that basis should be greater 

 

   than investment value. 

 

   c. 'Superfund' liability by past owners. Prior owners of 

 

   toxic waste dumps can be held liable for costs of cleaning up 

 

   the dumps. /93/ A prior owner gets no continuing rents from sold 

 

   land, so the costs are expired when made. The ephemeral future 

 

   value of being perceived as a good corporate citizen is not 

 

   enough to justify capitalization in a real-world tax system. 

 

   2. Examples of capital expenditure. Many mandatory environmental costs are capitalized because they give the taxpayer a continuing investment, which is worth more than basis.

 

    a. Water pollution equipment. Chemico A Inc. has always 

 

   discharged its arsenic effluent from making compound F into Lake 

 

   S. To comply with an EPA directive, Chemico A constructs 

 

   settling tanks and a filtration system. Chemico A also develops 

 

   existing technology for using microbes to make the arsenic 

 

   compounds precipitate out of its effluent. Under the Clean Water 

 

   Act, the costs are prerequisites for Chemico A to continue to 

 

   discharge its effluent into Lake S. The value of the right to 

 

   discharge effluent in the future is worth far more than the cost 

 

   A has incurred. A does not close its factory because the factory 

 

   is worth more than its costs. The costs are capital 

 

   expenditures. /94/ The basis of older equipment withdrawn from 

 

   service because of the change is an expired cost and deductible. 

 

   b. Asbestos removal. Owner D of a moderate income apartment 

 

   building removes the asbestos insulation from its apartments and 

 

   common areas, pursuant to an EPA directive, because the asbestos 

 

   would otherwise damage the lungs of apartment occupants and 

 

   visitors. Removal is a legal prerequisite for continued human 

 

   access to D's buildings. D removes the asbestos because the 

 

   value of the access to the buildings is in excess of the cost of 

 

   removal. The costs are capital expenditures. /95/ Loss on 

 

   buildings due to new rules on human exposure to asbestos is 

 

   unrealized loss recognized upon sale. /96/ 

 

   3. Economic performance is not sufficient. A recent commentary has argued that Congress intended environmental costs to be deducted when paid because of the time-value-of-money reforms enacted in the Deficit Reduction Act of 1984. David Efurd and Roy Strowd argue, erroneously, that environmental costs must be deducted when 'economic performance' occurs because section 461(h) governs the timing of income. /97/ Section 461(h), however, does not 'govern' timing; it is an antiabuse screen that can only hurt the taxpayer. It never can turn something considered capital expenditures or investments into current or expired costs. Section 461(h) merely denies that a promise to pay is a bona fide 'liability' to an accrual-tax method owing the amounts, until resources have been used, that is, until economic performance occurs. Before resources are used, no one will charge interest on the liability, and if the liability is not interest- bearing, it cannot be considered to be an economic detriment that reduces wealth or ability to pay tax on a par with a current payment in cash. Once the liability is respected, that does not mean it is an expense. Under the regulations, a liability that passes the section 461(h) screen can easily still be basis in a capital asset rather than an expense. /98/ Passing the screen carries no implication as to whether the liability is current or capitalized. Efurd and Strowd misunderstand the act. /99/ 

 

   4. Not for subsidy. It is sometimes argued that environmental costs should be expensed when made because they improve the world. Environmental investments are good investments that will improve the world. But then, most investments are world improving, or else they would not generate the investment return that comes from money that someone is willing to pay. Good investments are capitalized. Interpretation of the tax law needs to be done straight even in the environmental area. 

 

   A tax write-off, in any event, would be an inefficient and unfair way to deliver government subsidy. One of two things can happen when investments can be made with soft money and both of them are bad. Either (1) highest-bracket, 41-percent taxpayers bid up the price of the investment and drive all lower bracket competitors out of the bidding, or (2) multi-bracket investors survive, but the federal government then loses more in tax revenue to high-bracket investors than is delivered on site to the worthy activity. As a matter of postulate and proof, one cannot both have owners in different tax brackets and also have a system that does not waste the government's cost. /100/ Government checks  are cheaper, at least, because they can be delivered with 100-percent efficiency. In a multi-bracket system, the tax subsidy cannot be as fair, efficient, or rational as a government check. Subsidies, moreover, are more rational than tax advantages because tax advantages are hidden costs. Subsidies should always be required to compete against each other as open and identified costs in the federal budget process. 

 

   5. IRS work-in-progress. In meetings with practitioners, the IRS has informally identified five factors to consider when determining whether to capitalize environmental clean-up costs. /101/ The list is flawed work for the reasons noted immediately after each factor. 

 

   Factor 1: Whether the costs relate to creation of a new 

 

   piece of property or simply to the clean-up of existing 

 

   property. 

 

   The factor does not help because continued access to existing property is an asset and a capital expenditure with significant future value. Costs arising out of purchase of new property are also capitalized. 

 

   Factor 2: Whether the property to which the expense relates 

 

   is owned by the taxpayer.

 

   This factor is ambiguous; there is no continuing value to the oil company from cleaning up the Prince William Sound oil spill. There is, however, continuing value to Chemico A in achieving continued access to Lake S for the discharge of effluent, even though Chemico A does not own Lake S. 

 

   Factor 3: Whether the property to which the expenditure 

 

   relates will generate future income. 

 

   This factor helps; basis should not exceed the investment value of the property. 

 

   Factor 4: Whether the problem arose in the course of the 

 

   taxpayer's business operations while the taxpayer was earning 

 

   income or whether the property was acquired with the problem 

 

   already there. 

 

   If the remediation occurs at near the time of the acquisition, it is likely that the taxpayer bought the property for a cheaper price, reflecting the needed costs and that the costs are just part of the purchase price. But even if the investment arises later, investments are still capital expenditures, even if there was some precipitating loss. The factor conflates prior business losses, which are deductible, with new unexpired costs, which are not. 

 

   Factor 5: Whether the expenditure is voluntary or is 

 

   involuntarily imposed by a judicial or governmental decision. 

 

   This factor does not help. The tax character of settlements and judgments follows the character of the voluntary item it replaces. /102/ It does not matter whether the payment is voluntary or compelled. 

 

   The list as a whole hurts understanding more than it helps. There are traces here of the 'sunk-barge' fallacy. To use a list like this, moreover, you have to have a theory to tell which factors do not matter very much and which are determinative. Without a theory, lists like this may be filled with sound and fury, but they do not signify very much.

 

 

________________________________________________________________________________

 

                          IV. Conclusion and Summary

________________________________________________________________________________

 

   In INDOPCO v. Commissioner, /103/ the Supreme Court held that the fees paid by a target corporation in the course of a tax-free reorganization were capital expenditures because the fees produced significant value beyond the taxable year. The fees were apparently treated as costs of an improved corporate structure, so that the basis resulting from the fees would not be recognized for tax purposes until the entire corporate structure of the acquiring Unilever group was abandoned on liquidation. Other theories, still denying an immediate deduction, better described the facts. The fees could have quite reasonably been treated as dividends to the target shareholders. The fees also could have been treated as costs of a tax-deferred sale of assets, such that tax recognition of the costs would be deferred until the gain on the assets was recognized, even if the sale had no future value. Both parties argued the case before the Court, however, as a capital expenditure case, so the Court justifiably decided the case on the capitalization issue before it. Deciding that the fees were capitalized, the Court rejected the cases that would require that capitalized expenditures must produce a separate and distinct asset. Its holding means that costs with significant future value are capital expenditures, even when the future benefit on the facts is quite speculative. 

 

   The significant-future-value test, adopted by the Court, is a terrific test, bringing the legal doctrine for capitalization into conformity with good economics. Costs with significant future value are investments and, in an income tax, it is important to maintain consistently that investments be made and continued with nondeductible costs. A taxpayer's basis for its investments should not be allowed to be lower than the internal investment value of the taxpayer's costs. Violation of the directive that value equal basis tilts the competition for investments in favor of higher tax bracket investors. High-bracket taxpayers bid up the price of the tax deductible investments, either driving out lower bracket competitors completely or else retaining windfall lower effective tax rates that they do not pass on to the public good. 

 

   The significant future-benefit-test should yield an overruling of a number of prior decisions that tolerated expensing of investments with continuing value. The  test should clean up the law of prepayments, repealing some bogus materiality cases, and require capitalization of prepaid costs, whenever they are worth accounting for. The tests should reinforce Judge Murnaghan's fine decision in NCNB, capitalizing business expansion costs, and overrule the prior cases holding that business expansion costs could not be capitalized because they did not create a separate and distinct asset. The test, finally, should require capitalization of remedial and environmental clean-up costs, where the costs have continuing investment value. Whether the cost is an improvement or not should be judged from 'sea bottom' after the precipitating loss has occurred. The treatment of the new costs should not be conflated with the separate tax treatment of the precipitating loss. INDOPCO is, in sum, a big win for the government and goes a long way toward making tax accounting in the area of capitalization accurately describe the underlying economics.

 

 

________________________________________________________________________________

 

                                  FOOTNOTES:

________________________________________________________________________________

 

   /1/ 112 S. Ct. 1039 (1992). 

 

   /2/ Id. at 1045. 

 

   /3/ Id. at 1044. 

 

   /4/ Bryan Mattingly, 'Note, INDOPCO, Inc. v. Commissioner: Will the IRS Use a Nebulous Supreme Court Decision to Capitalize on Unsuspecting Taxpayers?' 81 Ky. L. J. 801, 802 (1993). 

 

   /5/ J. Phillip Adams and J. Dean Hinderliter, 'INDOPCO, Inc. v. Commissioner: Impact Beyond Friendly Takeovers,' Tax Notes, Apr. 6, 1992, p. 93 (INDOPCO should not be read as having erected a barrier to deduction of takeover expenses generally).

 

   /6/ Richard Lipton, Lynn Schewe, and Michael Fondo, 'Supreme Court Approves Focus on Long-Term Benefit in Takeover Expense Controversy,' 76 J. of Taxation 324, 326 (June 1992). 

 

   /7/ Paul Manca, 'Note, Deductibility of Takeover and Non- Takeover Expenses in the Wake of INDOPCO, Inc. v. Commissioner,' 45 Tax Lawyer 815, 825 (1992). 

 

   /8/ Lee Sheppard, 'Is the IRS Abusing INDOPCO?' Tax Notes, Aug. 31, 1992, p. 1110. 

 

   /9/ George Javaras and Todd Maynes, 'Business Expansion and Protection in the Post-INDOPCO World,' Tax Notes, May 18, 1992, p. 971. 

 

   /10/ John W. Lee, 'Doping Out the Capitalization Rules After INDOPCO,' Tax Notes, Nov. 2, 1992, p. 669 (INDOPCO should not prevent deduction of recurring expenses). 

 

   /11/ Henry Ruempler and Paul Salfi, 'Tax Treatment of Loan Origination Costs and Fees,' Tax Notes, Sept. 27, 1993, p. 1745, argue that a bank's costs in originating loans are ordinary business expenses that cannot be capitalized. The argument seems frivolous to me. Capital expenditures are business related; it is just that they continue to have value by year end. INDOPCO held that a separate and distinct asset is sufficient to mandate capitalization and, to the bank, the loans it originates are assets. The IRS and the courts need to reject the argument, even penalize it under the negligence penalties. 

 

   /12/ An investor in Column A of Table 1, with a hard-money investment (e.g., stock, land, or bonds) gets I(1-t) to invest, where I is pretax income dedicated to the investment and t is the tax rate. The column A investor then gets I(1-t)(1+R)n back pretax, where R is the pretax annualized return and n is the years of compound investment. If the profit is tax-exempt, then I(1-t)(1+R)n is also the posttax return. The column B soft-money investor does not have I reduced by tax and thus can get I(1+R)n back pretax. The column B investor has no basis, however, so tax at t leaves him with I(1+R)n(1-t), which is the same thing as the column A results of I(1- t)(1+R)n 

 

   /13/ In absence of tax, an investment with cost of C will give a terminal value of C(1+R)n. An investor under an income tax with soft money investing, who is willing to commit I that is immediately deductible can put amount I into the investment and save tax of tI (with t, equally the tax rate) by deducting I from taxable income otherwise subject to tax, so the after tax cost C is I-tI or I(1-t). Hence the investment I = C/(1-t) (or $100 in Table 1, col. B). Investment of C/(1-t) will yield a terminal value of [C/(1-t)](1+R)n pretax, which when subject to tax at t will reduce the return to [C/(1-t)](1+R)n(1-t), which equals just C(1+R)n, that is the final position in absence of tax. The value of the deduction of the investment I offsets the tax on the return and leaves the investor with no reduction in R, the pretax rate of return. 

 

   /14/ See, e.g, Cary Brown, 'Business-Income Taxation and Investment Incentives,' in Income, Employment and Public Policy: Essays in Honor of Alvin H. Hansen 300 (1948); Dep't of the Treasury, Blueprints for Basic Tax Reform 123-24 (1977); Stanley Surrey, 'The Tax Reform Act of 1969--Tax Deferral and Tax Shelters,' 12 B.C. Indus. & Com. L. Rev. 307 (1971); Calvin Johnson, 'Soft Money Investing under the Income Tax,' 1989 U. Ill. L. Rev. 101 (hereinafter 'Soft Money Investing').

 

   /15/ See, e.g., section 401 (qualified pension funds), section 501 (endowed charities and other tax-exempt funds). Statutory references are to the Internal Revenue Code of 1986, as amended, and the regulations promulgated thereunder, except as otherwise noted. 

 

   /16/ See, e.g., section 816 (life insurance company entitled to deduct life insurance reserves). 

 

   /17/ Section 446(b). 

 

   /18/ See, e.g., section 174 (research and experimental expenditures may be expensed when made). 

 

   /19/ Sections 1272-1274. 

 

   /20/ Section 475, enacted by the Omnibus Budget Reconciliation Act of 1993, section 13223(a). 

 

   /21/ See, e.g., Welch v. Helvering, 290 U.S. 111, 115 (1933) (Court holds that life in all its fullness must answer riddle of deduction). 

 

   /22/ Section 132(e). The definition of 'materiality' used by financial accounting is that an item is material if a user of the reports would be influenced by the report of the item. FASB, 'Qualitative Characteristics of Accounting Information,' Statement of Financial Accounting Concepts No. 2, sections 123-132, 161-170 (1980). Since the primary user of accounting material reported on tax returns is the IRS, that definition implies that costs should be capitalized if the IRS would be influenced by it. 

 

   /23/ Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 542 (1979). 

 

   /24/ According to the AICPA, the Big Six accounting firms face claims of $30 billion under accountant malpractice theories. Bix Six firms have paid settlements of $400 million to $500 million. Albert Crenshaw, 'Accountants Plead for Relief,' Washington Post, 1 (Dec. 12, 1993). 

 

   /25/ See, e.g., Mooney Aircraft, Inc. v. United States, 420 F.2d 400, 410 (5th Cir. 1969). Immediate deduction of future costs is criticized in Calvin Johnson, 'Silk Purses from a Sow's Ear: Cost Free Liabilities Under the Income Tax,' 3 American J. of Tax Policy 231 (1984). 

 

   /26/ 'Soft Money Investing,' supra note 14 at 1079. See discussion accompanying notes 86-87 infra. 

 

   /27/ Bittker & Eustice, Federal Income Taxation of Corporations & Shareholders, section 5.06, at 5-33 (5th ed. 1987). 

 

   /28/ Section 6662(d)(2)(B) (accuracy-related penalty does not apply to positions for which there is 'substantial authority,' unless disclosed on the return). 

 

   /29/ See, e.g., Sammons v. Commissioner, 472 F.2d 449, 452 (5th Cir. 1972). 

 

   /30/ Calvin Johnson, 'The Expenditures Incurred by the Target Corporation in an Acquisitive Reorganization are Dividends to the Shareholders: (Pssst, Don't Tell the Supreme Court),' Tax Notes, Oct. 28, 1991, p. 463 (hereinafter 'Johnson Dividends'). 

 

   /31/ Petition for Writ of Certiorari in INDOPCO, Inc. v. Commissioner, Docket No. 90-1278, at 2-3 (1990), available from Tax Analysts as Doc 91-3926. 

 

   /32/ Accounting Principles Board Opinion No. 16, Business Combinations, section 16 (1970). 

 

   /33/ Johnson Dividends, supra note 30, at 466-471. 

 

   /34/ Section 362. 

 

   /35/ Alphaco, Inc. v. Nelson, 385 F.2d 244, 245 (7th Cir. 1967); Johnson Dividends, supra note 30, at 473. 

 

   /36/ Section 362. 

 

   /37/ Section 337. 

 

   /38/ Section 334(b). 

 

   /39/ General Bancshares Corp. v. Commissioner, 326 F.2d 712, 715 (8th Cir. 1964) (Blackmun, J.) cert. denied 379 U.S. 832 (1964), cited with approval by INDOPCO v. Commissioner, 112 S. Ct. 1039, 1044-46 (1992)(Blackmun, J.); aff'g sub nom National Starch v. Commissioner, 918 F.2d 426, 428, 433-434 (3d Cir. 1990); McCrory Corp. v. United States, 651 F.2d 828, 832 (2d Cir. 1981); E.I. duPont de Nemours and Co. v. United States, 432 F.2d 1052, 1059 (3d Cir. 1970); Mills Estate Inc. v. Commissioner, 206 F.2d 244, 246 (2d Cir. 1953). 

 

   /40/ Johnson Dividends, supra note 30, at 476-477 (arguing that the $2.7 million costs were in the nature of goodwill acquisition costs, so that they could not be recognized until the target company was broken up or sold. The costs should be the last thing recovered and remain intact so long as the business remains intact). 

 

   /41/ 112 S.Ct. at 1046. 

 

   /42/ Following case below, National Starch and Chemical Corp. v. Commissioner, 918 F.2d 426, 429-430 (3d Cir. 1990) and Cleveland Elec. Illum. Co. v. United States, 7 Ct. Cl. 220, 225, 55 AFTR.2d 85- 652, 655 (1985) and rejecting NCNB Corp. v. United States, 684 F.2d 285, 293-294 (4th Cir. 1982 en banc); Briarcliff Candy Corp. v. Commissioner, 475 F.2d 775, 782 (2d Cir. 1973). 

 

   /43/ The 'no-asset-required' holding may come to mean, especially, that expenditures can be capitalized even though the taxpayer cannot get access to or refund of the money. In Black Hills Corp. v. Commissioner, 102 T.C. No. 102 (1994) (Halperin, J.) the Tax Court, on rehearing, was informed that big front-loaded insurance premiums the taxpayer paid were not refundable. The Court responded that the nonrefundability meant that the premiums were not an asset to the taxpayer, but that premiums still had to be capitalized under INDOPCO because they had future value. 

 

   /44/ Section 197(e)(8) enacted by Omnibus Budget Reconciliation Act of 1993, P.L.103-66, section 13261(a) (hereinafter OBRA of 1993).

 

   /45/ Calvin Johnson, 'The Mass Asset Rule Reflects Income and Amortization Does Not,' Tax Notes, Aug. 3, 1992, p. 629, argues that amortization of goodwill and other such intangibles leads to too low effective tax rates. 

 

   /46/ See Staff of the Joint Committee on Taxation, Description of Proposals Relating to the Federal Income Tax Treatment of Certain Intangible Property at 5-18 (Comm. Print, Sept. 30, 1991). 

 

   /47/ Cf., e.g., Jane Gravelle and Jack Taylor, 'Tax Neutrality and the Tax Treatment of Purchased Intangibles,' 40 Nat. Tax J. 77, 85 (March 1992) (arguing that reducing tax rate would reduce lock-in but that lock-in is more serious for other assets); Michael Kliegman, Letters to the Editor: 'Intangibles Legislation Will Not Fund Uneconomic Acquisitions,' Tax Notes, Aug. 9, 1993, p. 804, (arguing that General Utilities repeal prevents uneconomic takeovers, even with rapid amortization); see contra, Calvin Johnson, 'Amortization of Intangibles: Impact of Seller Tax,' Tax Notes, Apr. 12, 1993, p. 285 (arguing that repeal of General Utilities was not good policy and that buyer side amortization was not an ideal way to accomplish it). 

 

   /48/ Calvin Johnson, Letter to the Honorable Fred J. Goldberg, Assistant Secretary for Tax Policy, 'Reorganization Expenses under HR 3035,' 92 TNT 150-72 (arguing for excluding INDOPCO expenditures from section 197). 

 

   /49/ Manca, 'Note, Deductibility of Takeover and Non-Takeover Expenses in the Wake of INDOPCO, Inc. v. Commissioner,' 45 Tax Lawyer 815, 825 (1992) (noting concern over how far language can be 'stretched'); J. Phillip Adams and J. Dean Hinderliter, 'INDOPCO, Inc. v. Commissioner: Impact Beyond Friendly Takeovers,' Tax Notes, Apr. 6, 1992, p. 93 (INDOPCO should not be read as having erected a barrier to deduction of takeover expenses generally). Neither article, however, makes any useful suggestion as to how hostile, but successful, takeovers might be distinguished. 

 

   /50/ 99 T.C. 648, 662, 665 (1992). 

 

   /51/ Alphaco, Inc. v. Nelson, 385 F.2d 244, 245 (7th Cir. 1967); Johnson Dividends, supra note 30, at 473. 

 

   /52/ Spreckels v. Commissioner, 315 U.S. 626, 628-29 (1942) (stock broker's commissions); Third National Bank in Nashville v. United States, 427 F.2d 343, 344 (6th Cir. 1970) (dissenter's costs in merger appraisal litigation); Treas. Reg. section 1.263(a)-2(e) (expenses of capital gain offset gain). 

 

   /53/ 1992-1 USTC section 50,097 (Bankr. S.D. Ohio 1992). 

 

   /54/ See, e.g., Libson Shops, Inc. v Koehler, 48 AFTR 1988, 1993 (E.D. Mo. 1955) (costs of rejected alternative ways to merge corporations to preserve net operating losses were not abandoned costs, because rejected and adopted alternatives were all done with one purpose in mind) aff'd on another issue, 229 F.2d 220 (8th Cir. 1956), aff'd, 353 U.S. 382 (1957). 

 

   /55/ The discussion in text of prepaid fees draws heavily on 'Soft Money Investing,' supra note 14, at 1079-86. 

 

   /56/ Williamson v. Commissioner, 37 T.C. 941, 943 (1962) (prepaid rent); Commissioner v. Boylston Market Ass'n, 131 F.2d 966, 968 (1st Cir. 1942) (prepaid insurance); Blitzer v. United States, 684 F.2d 874, 894 (Ct. Cl. 1982) (prepaid services). See 4 B. Bittker, Federal Taxation of Income, Estates and Gifts, par. 105.2.5, at 105-45 (1981) (capitalization of prepaid expenses is the 'prevailing and better view'). 

 

   /57/ INDOPCO, Inc. v. Commissioner, 112 S. Ct. 1039, 1045 (1992). 

 

   /58/ Waldheim Realty & Inv. Co. v. Commissioner, 245 F.2d 823, 825 (8th Cir. 1957) (prepaid insurance need not be capitalized because expense is something different from capital asset). 

 

   /59/ 616 F.2d 429 (9th Cir. 1980). 

 

   /60/ 616 F.2d at 432, 433. 

 

   /61/ See, e.g., Commissioner v. Van Raden, 650 F.2d 1046, 1050 n. 7 (9th Cir. 1981) (slightly more than a year's worth of undelivered cattle feed was expensed). 

 

   /62/ Sorrell v. Commissioner, 53 T.C.M. (CCH) 1362 (1987) rev'd on other grounds, 882 F.2d 484 (11th Cir. 1989); Grynberg v. Commissioner, 83 T.C. 255, 266-68 (1984). 

 

   /63/ Packard v. Commissioner, 85 T.C. 397, 428 (1985) (prepaid cattle feed); Keller v. Commissioner, 79 T.C. 7, 28 (1982) (prepaid intangible drilling costs) aff'd 725 F.2d 1173 (8th Cir. 1984); Van Raden v. Commissioner, 71 T.C. 1083, 1105-06 (1979), aff'd on other grounds, 650 F.2d 1046 (9th Cir. 1981). There is no logical power to the argument that consent by the recipient implies that there is no tax motive for the prepayment. The recipient of a prepayment easily might be an accommodation party who is not hostile to an early payment of its receivables. Firms commonly tolerate early payment or even prepayment of their receivables, in the ordinary course of a trade or business, because their collection risks go down. Syndicated shelter promoters, moreover, who are selling the tax advantages of prepayments have proven not be very good enforcers preventing material prepayments. 

 

   /64/ 38 T.C.M. (CCH) 950, 952, 954 (1979). Real access to the common-law advantages of cases like Haynes, especially by nonfarmers who do not have mud on their boots, has been drastically restricted by Congress by the enactment of a great number of anti-tax shelter overrides. See, e.g., section 263A (uniform capitalization); section 447 (mandatory accrual rules); section 461 (prepaid expenses); section 464 (deferring deductions until use of supplies); section 469 (passive loss limitations). 

 

   /65/ See statutes cited, supra note 64. 

 

   /66/ 651 F.2d 942 (4th Cir. 1981) (Murnaghan, J.). 

 

   /67/ 731 F.2d 1181, 1185 (5th Cir. 1984). 

 

   /68/ NCNB Corp. v. United States, 684 F.2d 285 (4th Cir. 1982) (en banc). 

 

   /69/ Section 195(c)(1)(A).

 

   /70/ George Javaras & Todd Maynes, 'Business Expansion and Protection in the Post-INDOPCO World,' Tax Notes, May 18, 1992, p. 971. 

 

   /71/ Section 195(c)(1)(B). 

 

   /72/ See, e.g., Frank v. Commissioner, 20 T.C. 511 (1953) (taxpayer denied deductions for costs of investigating purchase of businesses); 1 Boris Bittker and Larry Lokken, Fed. Taxation of Income, Gifts and Estates, section 20.4.4 (2d ed. 1989) (criticizing the disallowance of a deduction when the investigation is abandoned). 

 

   /73/ Treas. Reg. section 1.165-7(b) (1977). 

 

   /74/ Treas. Reg. section 1.162-4 (1958). 

 

   /75/ Wolfsen Land & Cattle Co v. Commissioner, 72 T.C. 1, 11-13 (1979) (costs of digging out silted irrigation ditch were separate 10-year asset, not an addition to nondepreciable land basis). 

 

   /76/ Cf. Treas. Reg. section 1.165-7(a)(2)(ii) (1977) (cost of repair is sometimes acceptable measure of casualty loss). 

 

   /77/ Dean v. Commissioner, 35 T.C. 1083, 1090 (1961) (presuming that interest would automatically offset dividend income). 

 

   /78/ The hypothetical is based on Zimmern v. Commissioner, 28 F.2d 769 (5th Cir. 1928). 

 

   /79/ Treas. Reg. section 1.165-7(b)(1977) (remaining basis of destroyed business asset is deducted). 

 

   /80/ Zimmern v. Commissioner, 28 F.2d 769 (5th Cir. 1928) (cost of raising barge is expensed). 

 

   /81/ Plainfield-Union Water Co. v. Commissioner, 39 T.C. 333, 338 (1962) (lining water pipes with cement); Oberman Mfg. Co. v. Commissioner, 47 T.C. 471, 482-83 (1967) (structural change to leaky roof); Midland Empire Packing Co. v. Commissioner, 14 T.C. 635, 642 (1950) (oil-proofing basement); American Bemberg Corp. v. Commissioner, 10 T.C. 361, 375-78 (1948) (with dissent) (repair of underpinnings to prevent building from collapsing), aff'd per curiam, 177 F.2d 200 (6th Cir. 1949); Illinois Merchants Trust Co. v. Commissioner, 4 B.T.A. 103, 107 (1926) (repair of building underpinnings). 

 

   /82/ 93 U.S. 225, 227 (1876). 

 

   /83/ 231 F.2d 876, 879-80 (9th Cir. 1956). 

 

   /84/ Connally Realty Co. v. Commissioner, 81 F.2d 221, 222 (5th Cir. 1936) (property is worth more with alterations, even though not worth more than before the change of conditions). Teitelbaum v. Commissioner, 294 F.2d 541, 544 (7th Cir. 1961) (conversion from DC to AC electrical current ordered by city) cert. denied 368 U.S. 987 (1962); Woolrich Woolen Mills v. United States, 289 F.2d 444, 448 (3d Cir. 1961) (antipollution system added to taxpayer's plant after state threats of injunction); RKO Theatres, Inc. v. United States, 163 F. Supp. 598, 599 (Ct. C. 1958) (fire exits ordered by state); Mt. Morris Drive-In Theatre Co. v. Commissioner, 25 T.C. 272, 274 (1955) (drainage system installed under threat of litigation by downgrade landowner), aff'd per curiam, 238 F.2d 85 (6th Cir. 1956); Trenton-New Brunswick Theatres Co. v Commissioner, 13 T.C.M. (CCH) 550, 551 (1954) (fire passageway built under orders of the city building inspector); Hotel Sulgrave, Inc. v. Commissioner, 21 T.C. 619, 621 (1954) (sprinkler system ordered by city); International Bldg. Co. v. Commissioner, 21 B.T.A. 617, 621 (1930) (safety features on elevator); Bonwit Teller & Co. v. Commissioner, 17 B.T.A. 1019, 1026-27 (1929) (coal to oil furnace) rev'd on other grounds 53 F.2d 381 (2d Cir. 1931), cert. denied 284 U.S. 690 (1932); Rev. Rul. 77- 478, 1977-2 C.B. 81 (construction to protect railroad track embankment from water damage); Rev. Rul. 60-386, 1960-2 C.B. 107 (sea wall dikes and drainage system built to protect against damage from sea after land subsided); Rev. Rul. 79, 1953 C.B. 41 (costs in constructing protective barrier and moving houses to prevent storm losses to property abutting Great Lakes). 

 

   /85/ Woodside Cotton Mills Co. v. Commissioner, 13 B.T.A. 266, 269-270 (1928). 

 

   /86/ Alan Gunn, 'The Requirement That a Capital Expenditure Create or Enhance an Asset,' 15 B.C. Indus. & Com. L. Rev. 443, 455 (1974); John W. Lee, 'Start-Up Costs, Section 195, and Clear Reflection of Income: A Tale of Talismans, Tacked-On Tax Reform, and a Touch of Basics,' 6 Va. Tax Rev. 1, 18-20 (1986); John W. Lee, 'Doping Out the Capitalization Rules After INDOPCO,' Tax Notes, Nov. 2, 1992, p. 669. 

 

   /87/ 'Soft Money Investing,' supra note 14, at 1072-77. 

 

   /88/ Tax Executive Institute, Federal Tax Committee, 'Comments on The Proper Income Tax Treatment of Environmental Remediation Expenditures,' 45 The Tax Executive 307, 311, 315-16 (July-Aug. 1993), commenting on TAM 9240004 (cost of removing asbestos insulation from pipes and machinery was capital expenditure). 

 

   /89/ It might also be true that the loss because of changing public expectations with respect to asbestos is an unrealized loss. If so, the policy of unrealized losses should be preserved and not circumvented through an indirect deduction, i.e, the deduction of the new investment. Reggio v. United States, 151 F.Supp. 740, 741 (Ct. Cl. 1957) (bondholder was taxed on settlement paid when issuer reduced interest rate; bondholder held to have combination of in- lieu-of-interest income and unrealized loss on the bond). 

 

   /90/ Financial Accounting Standards Board, 'Statement of Financial Accounting Standards No. 16, Prior Period Adjustments,' sections 11, 12 (1977). 

 

   /91/ Clean Water Act, 33 U.S.C. sections 1251-1387. 

 

   /92/ Section 461(h)(2)(B). 

 

   /93/ CERCLA, 42 U.S.C. sections 9601-9675. 

 

   /94/ Woolrich Woolen Mills v. United States, 289 F.2d 444, 449 (3d. Cir. 1961). 

 

   /95/ TAM 9240004 (cost of removing asbestos insulation from pipes and machinery was capital expenditure). Supporting authority includes RKO Theatres, Inc. v. United States, 163 F. Supp. 598, 602 (Ct. C1. 1958) (fire exits ordered by state were capital); Trenton- New Brunswick Theatres Co. v Commissioner, 13 T.C.M. (CCH) 550, 551 (1954) (fire passageway built under orders of the city building inspector); Hotel Sulgrave, Inc. v. Commissioner, 21 T.C. 619, 621 (1954) (sprinkler system ordered by city); International Bldg. Co. v. Commissioner, 21 B.T.A. 617, 621 (1930) (safety features on elevator). 

 

   /96/ Reggio v. United States, 151 F.Supp. 740, 741 (Ct. Cl. 1957) (bondholder was taxed on settlement paid when issuer reduced interest rate; bondholder had income in lieu of interest and unrealized loss on the bond). 

 

   /97/ David Efurd and Roy Strowd Jr., 'A DRA 1984 Perspective Concerning the Deductibility of Environmental Costs, Tax Notes, Mar. 21, 1994, p. 1585. 

 

   /98/ Treas. Reg. section 1.461-4(a)(1)(1993) by reference to section 1.446-1(c)(1)(ii)(B) mentioning liabilities that are capital expenditures. 

 

   /99/ Efurd and Strowd also argue that section 468, allowing a deduction for additions to a reserve for mine closing and reclamation costs, justifies the deduction for environmental costs as ore is mined, because environmental costs are akin to closing and reclamation costs. Costs incurred when the mine is closed can be deducted then because the costs have no further income-producing value. Section 468 does allow the costs to be deducted before the closing occurs, but section 468(a)(2)&(4) reduce the deduction by interest to take account of the time value of money, with the intent of taking away any advantage from deducting the costs before the costs are paid. Section 468 is intended to be just the economic equivalent of deducting expired costs, after they expire. It is not intended to justify the deduction of costs with future benefit, which have not expired. 

 

   /100/ See Calvin Johnson, 'Is an Interest Deduction Inevitable?' 6 Va. Tax Rev. 126, 161-170 (1986). 

 

   /101/ J. Avakian-Martin, 'IRS Struggles for Bright-Line Rules on Cleanup Costs,' Tax Notes, Mar. 15, 1993, p. 1408. 

 

   /102/ See, e.g., Lyeth v. Hooey, 305 U.S. 188 (1938); Sager Glove Corp. v. Commissioner, 36 T.C. 1173, 1180 aff'd 311 F.2d 210 (7th Cir. 1962) cert. denied 373 U.S. 910 (1963). 

 

   /103/ 112 S. Ct. 1039 (1992). 

 

 

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