This shelf project proposal covers several expenditures that are allowed as expenses as soon as they are incurred under current law but should be treated as capital expenditures. Given the treatment of debt financing, capitalization is needed to prevent negative tax or subsidy for investments, many with dubious merit. The expensing subsidy allows projects to go forward that would lose money in the absence of tax. Absence of pretax profit is a prima facie indicator that the project should not go forward.
Previous shelf projects within the series have recommended capitalization of the costs of development of computer software and capitalization of all prepayments while they remain prepayments. In overview, this project defends a strong law of capitalization and then defends capitalization of an omnibus list of specific items.
The proposal would reverse current regulations on investment in intangibles on several issues. It would capitalize employee or officer compensation paid to investigate or effect a corporate acquisition, a change of capital structure, or a multiyear contract. The proposal would capitalize costs of package design and allow amortization over 15 years. The proposal would capitalize the costs of application for a patent and allow amortization over 20 years. The costs of terminating an existing contract would be capitalized and amortized over the remaining life of the extinguished contract.
The proposal would also repeal special statutory provisions that allow expensing of investment costs. Costs of annual crops harvested after year-end or after the sale or gift of the land would be capitalized. Direct and indirect costs of investigating and developing oil and gas and other mineral deposits would be capitalized and recovered by cost depletion. Direct and indirect costs of film and television production would be capitalized. The special expensing under section 179 for $250,000 of depreciable property would be repealed. The proposal would capitalize the costs of service providers when expenses of a capital project or litigation exceed $1 million and the costs are reasonably expected to be recovered by future fees.
A. General Defense of a Strong Law of Capitalization
Section 263 disallows deductions made to increase the value of any property or estate. If section 263 did not exist, its core would be implied afresh from the nature of income. Thus capitalization is said to be ‘‘a basic principle of income taxation rather than a technical requirement imposed by specific statutory language.’’ Capital expenditures are investments, and investments are included within the tax base of an income tax. Allowing a deduction of investment costs, moreover, is usually as valuable as not taxing the subsequent income from the investment, and indeed is commonly more valuable than mere exemption of subsequent income.
As an accounting matter, costs are capitalized because ‘‘the Code endeavors to match expenses with the revenues of the taxable period to which they are properly attributable, thereby resulting in a more accurate calculation of net income for tax purposes.’’ Capitalized costs become basis, depreciated or amortized against the future benefits the costs produce: ‘‘The purpose of depreciation accounting is to allocate the expense of using an asset to the various periods which are benefited by that asset.’’ The purpose of section 263 is said to be to‘‘prevent a taxpayer from utilizing currently a deduction properly attributable… to later tax years when the capital asset becomes income producing.’’ Capitalized costs are business-related costs that have not expired and become lost by the end of the accounting year because they produce benefits in future years. Ordinary business expenses are just those capital expenditures that have expired by year-end.
A consumption tax would treat savings more generously. Under a consumption tax, either profit from investment would be exempted from tax or investment costs would be deducted immediately when paid. Our tax system is an income tax at its core, as indicated best by our respect for debt financing of an investment. When deduction of interest is allowed, as it generally is in our income tax, the combination of expensing of investment and the interest deduction yields a tax rate of less than zero. That combination produces not revenue for Uncle Sam, but a subsidy for the investment
Expensing of investments allowed by current tax law, moreover, creates an uneven field in which some investments are expensed and some are not. Some of our least meritorious investments, including, for instance, Lorillard Cigarettes and computer games like Doom 3 and Grand Theft Auto IV, take the greatest advantage of expensing. More generally, the negative tax from the combination of expensing and interest deductions allows investment projects to go forward that would never carry their cost of capital in the absence of tax. Tax should not induce twaddling investments that do not carry their costs. Loss on a pretax basis, considering the cost of capital, is a terrible screen to identify investments that should be subsidized. Thus, for example, we borrow as a nation from the Chinese, paying 5 percent interest, and invest at a return of 3.25 percent. In real terms, we are worse off by 1.75 percent every year. But given the tax subsidy, the private incentives from expensing are to go forward with the mediocre, money-losing investment.
It is one thing to move to a consumption tax uniformly and disallow interest deductions. It is quite another to continue the interest deduction and give some activities expensing while giving other industries only basis for their investment costs.
Notwithstanding ‘‘the importance of a ‘strong law of capitalization’ to the tax system,’’ expensing of various investments has crept into the income tax system over the years. Part of the explanation is a strong underappreciation of the economic damage from expensing. Part of it is a ‘‘tragedy of the commons’’ in politics, under which the special exemptions systematically triumph over the common good. The public cannot be organized to protect the general welfare because the interest of each member of the public in a fair and uniform tax system is too low, and the interest of those seeking a special exemption is so intense. An angry antitax attitude across the board also makes it hard to defend a firm, sound tax base that will do the least harm to the total welfare.
Congress also gives out subsidies via tax expensing as if it did not think that it was dealing with real money. For example, sections 616 and 617 allow a deduction for the exploration and development of a mine or other mineral deposit. Exploration and development of mineral deposits are massive investments, and sections 616 and 617, in economic effect, exempt from tax all the income from the investments. Corporations that develop deposits are allowed to deduct interest. Combining the expensing and the interest deduction creates a subsidy, not government revenue. The predecessor to section 616 was adopted in 1951. The best explanation of that provision is testimony by the chair of the tax committee of the American Mining Congress, who said that ‘‘the present emergency has found our country sadly deficient in the metals and minerals essential for our civilian economy and the rearmament effort.’’ The ‘‘present emergency’’ referred to in 1951 was the Korean War. It has been over a half century since the government has asked whether it has gotten its money’s worth from the subsidy entailed in giving up the tax. Indeed, it is doubtful from the legislative history that anyone determined that section 616 would survive a cost-benefit analysis when the section was enacted. This is not the kind of responsible budgeting that will ensure that the government-carried costs of negative tax are focused efficiently to achieve the most good for the least possible cost.
Uniform capitalization of investment costs would need to be achieved as a part of a strong overall drive to raise revenue when raising revenue is part of a national emergency attributable to budget deficits. When revenue is to be raised, it will do less harm to the private economy to go after negative tax rates before raising tax rates on activities that are now within taxable income. In 1792 a delegate to the French National Assembly said, ‘‘We only made the Revolution to become masters of taxation.’’
The French ancient regime had used a tax system so riddled with privileges and libertés that the most prosperous nation in Europe could not pay its public debts. We will similarly need energy amounting (almost) to a revolution in tax to make our tax system more rational.
This shelf project proposal would redraft section 263(a) to strengthen the clarity of its logic. Section 263(a)(1) now creates a general rule that improvements and betterments are capitalized, and it then lists exceptions in which expensing is allowed. The provision would be easier to read and comprehend if subsection (a) listed various capital expenditures that are instances of the general rule. Subsection 263(b), which is not now in use, would then list various items that are not capital expenditures. The proposed redrafted section 263(a) functions as a preview of the issues covered by this report:
Proposed redraft of the start of section 263: Section 263
a) General rule — No deduction shall be allowed for capital expenditures and investments, including, but not limited to
1) Improvements and betterments. Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate.
2) Restoration. Any amount expended in restoring property or making good the exhaustion thereof for which an allowance is or has been made.
3) Prepayments. Prepayments, including
A. payments for services before the services are performed;
B. payments for goods before the goods are delivered;
C. payments for use or rental of property before the time of use has passed;
D. payments of interest for the use or forbearance of money before the time of use or forbearance has passed; and
E. as guided by regulations promulgated by the Secretary, payments of any kind made before the quid pro quo for the payments is delivered or used.
4) Acquisitions and capital structure. Direct and indirect costs of considering, planning, and effecting the acquisition of a shareholder or partnership interest and a change of capital structure, including compensation paid to outsiders, to employees, members of the board of directors, and partners of the taxpayer.
5) Contracts. Direct and indirect costs of considering, creating, or improving a contract lasting beyond the end of the tax year, including compensation paid to outsiders, to employees, members of the board of directors, and to partners of the taxpayer.
6) Contract terminations. Costs paid to terminate a contract that would have ended after the end of the tax year.
7) Product and package design. Direct and indirect costs of product and package design giving benefits beyond the end of the tax year. See section 167 — providing for 15-year tax life.
8) Patents. Direct and indirect costs of application for and defense of a patent. See section 167 — providing for 20-year tax life.
9) Annual crops. Direct and indirect costs of annual crops harvested after sale or gift of the crops or after the end of the tax year.
10) Oil and gas. Direct and indirect costs of investigating and developing an oil and gas deposit. See section 612 for recovery of cost by cost depletion.
11) Mineral deposit. Direct and indirect costs of investigating and developing a mineral deposit. See section 612 for recovery of cost by cost depletion.
12) Film and television. Direct and indirect costs of film or television production.
13) Service provider’s costs. Direct and indirect costs of providing services when fees to be received after the end of the tax year are reasonably expected to exceed $1 million.
b) Exceptions to the general rule. Capitalization shall not be required, including for the following items:
1) De minimis costs. De minimis costs defined, as specified under regulations, as costs too small to be worth the extra burden of capitalization of the costs that would not be incurred if the costs were recorded as expenses. Importance of capitalization for a single plan or order will be determined by aggregating all costs of the plan or order to determine whether the expenditure is large enough to be capitalized.
The omnibus proposal would also repeal section 179, expensing of up to $250,000 of depreciable property.
B. Explanations of Proposed Section 263
1. Carryover language. Paragraph (1) of the proposed rewritten subsection 263(a) would include in its list of capital expenditures improvements and betterments. Paragraph (2) would include restorations making good the exhaustion of property. The language of (1) and (2) merely repeats current law. Proposed paragraph (3) on prepayments repeats the proposal from an earlier shelf project in this series on capitalization.
2. Review of regulations on intangible investments. Regulations promulgated in 2003 on the capitalization of investments in intangibles need to be reviewed. They were written with too much zeal to reduce revenue on key issues. The shelf project anticipates that revenue will need to be raised by being stricter about capitalization of investment costs.
a. Costs of investigation of a corporate restructuring. Under INDOPCO v. United States, the Supreme Court held that the transaction costs of accomplishing a corporate acquisition or change of capital structure are capital expenditures. The current Treasury regulations give homage to the Supreme Court’s INDOPCO decision as a general principle, but the regulations then exclude most of the costs of the transactions by allowing expensing of costs until the plans are finalized. Costs incurred before the taxpayer signs a letter of intent to go into the acquisition and before the taxpayer’s board of directors approves material terms of the deal are treated as immediate expenses under the current regulations. Those dates are late in the process of an acquisition; they occur when the investigation of the transaction is over, consideration of alternatives is complete, and the plans have been finalized except for details. The late date means that a large portion of the costs of investigating, planning, drafting, and effecting the acquisition are expensed immediately, which is inconsistent with the governing INDOPCO principle.
The cost of a transaction is a broad concept that sweeps in both the direct and the indirect costs. Costs must include everything that needs to be covered before the taxpayer can be said to make a profit. Best accounting allocates all of the overhead costs of a business firm to some profit-making nexus to give the firm optimal control of its costs. Most companies use full absorption accounting because all costs, including overhead costs, must be recovered to stay in business. Accounting that does not allocate overhead is short term, and short sighted, accounting, because over the long term, a business must recover all of its costs from the sale of some product. Full allocation of overhead is required to test effectively whether an activity meets a cost benefit test.
Accounting that excludes indirect costs means that the taxpayer will misunderstand its own costs and go into transactions that are unsound as a matter of economics.
Cost of a transaction includes consideration of alternatives. Thus, for example, the attorney fees paid for considering rejected alternatives are not lost costs, but rather are part of the costs of the overall plan Projects that were mutually exclusive to start with are always part of the same overall plan; abandonment of one alternative of a set of mutually exclusive projects is not a loss. Instead, the cost of the abandoned alternative is properly added to the basis of the alternative that is chosen. Moreover, ‘‘that the decision to make the investment is not final at the time of the expenditure does not change the character of the investment.’’ The costs incurred in considering and preparing for a multimillion dollar or billion dollar transaction are themselves material, well worth accounting for correctly as part of the transaction. The proposal in paragraph (4) of rewritten section 263(a) would list as a capital expenditure the cost of considering, planning, and effecting acquisition of a corporate or partnership interest and a change of capital structure.
For multiyear contracts, the current intangible regulations similarly expense the early costs of the total process of considering, planning, or effecting the transaction by using a cutoff date that occurs when the contracting process is almost complete. Under the regulations, costs incurred before the earlier of the time the taxpayer begins preparing a bid or the time the taxpayer begins discussing or negotiating the agreement with another party are treated as per se expired costs, deductible immediately.
As with the costs of a corporate acquisition, the costs of considering, planning, and effecting an acquisition of a capital asset such as a multiyear contract are a part of the cost, even though the taxpayer is not quite ready to make a bid or begin discussions. Paragraph (5) of rewritten subsection 263(a) would categorize those costs as capital expenditures. Future regulations, court decisions, and revenue rulings might offer some bright-line rules for capitalization, but the lines adopted will need to capitalize substantially all the costs of considering and preparing the contract.
b. Employee compensation. Under the current intangibles regulations, employee compensation is not considered a cost of the acquisition or the creation of an intangible. Guaranteed payments to a nonemployee partner and payments to directors are treated like employee compensation and are also immune from capitalization. Thus, the amounts paid to outside investment bankers and corporate lawyers to accomplish a tender offer or merger, for example, are capital expenditures (provided either the letter of intent or board approval has occurred), but the identical activities performed by inhouse investigators or in-house counsel are expensed costs. Similarly, an amount paid to outside counsel to draft and negotiate a contract is capitalized (after the discussions have started or the bid has been prepared), but the identical activities performed in house are per se expired costs, deductible when incurred. Similarly, paying outside appraisers in buying a pool of 30-year subprime mortgages is a capitalized cost, but the salaries paid to full-time employees to buy a pool of 30-year subprime mortgages are treated as if they expired immediately.
This shelf project proposal would capitalize employee and officer costs paid in connection with a corporate acquisition or change of capital structure. The regulations are inconsistent with the weight of the case law. In Idaho Power Co. v. Commissioner, for instance, the Supreme Court stated the governing rule that ‘‘when wages are paid in connection with the construction or acquisition of a capital asset, they must be capitalized and are then entitled to be amortized over the life of the capital asset so acquired.’’ The officer and employee’s salary of acquiring a capital asset are part of the cost basis of the asset. Overhead, including management salary, is capitalized, for instance, when buildings are constructed by taxpayer’s employees and supervised by officers.
The proposal would, however, reverse Wells Fargo v. Commissioner, in which the Eighth Circuit held that salaries of officers and board members paid for the time they spent on a corporate reorganization did not have to be capitalized because they were fixed costs. There ‘‘was no increase in their salaries attributable to the acquisition, and they would have been paid the salaries whether or not the acquisition took place.’’ The Wells Fargo court concluded that the salaries arose from the employment or board-of-directors relationship and were only indirectly related to the capital acquisition.
Wells Fargo is a terrible way to look at cost. The Wells Fargo argument that the officers would have to be paid regardless whether they worked on the acquisition implies that employees are paid whether or not they did any work at all. The attitude means that the firm is in fact acting as if employees can do anything they want, including goof off, because pay is a fixed and unavoidable cost. Employees are, in fact, a precious resource — a cost and they are not allowed to be idle and waste time. In a world where employees are put to work on one project if not another, the salaries are not a sunk or fixed cost related to nothing.
Costs of a capital project, moreover, include the allocable portion of fixed costs. Top management costs are often considered to be overhead costs allocated in cost accounting systems by a percentage burden of the direct labor costs involved in making inventory, but even overhead is an indirect cost of a capital project. The salaries of the officers and directors are part of the costs of the reorganization.
Treating employee compensation as a per se expired cost even when it is part of the acquisition of a capital asset gives the taxpayer a strong incentive to bring services in house, even at the cost of considerable economic damage. As a matter of economics, outside professionals often get to be more specialized at what they are doing because they get to see many transactions of the same kind. In-house counsel get to see only the transactions of one firm. In-house counsel often need to be jacks of all trades because the legal work presented to them varies so much. The wisdom in medicine is that if you need a brain operation, go to a specialist who does 10 of them a week. That wisdom applies to other kinds of professionals as well. Because of specialization, payments to outside counsel would be a more efficient expenditure. If a 35 percent deduction is available under expensing for in-house counsel, however, the firm will do the uneconomic thing and use in-house counsel. Tax should not encourage bad economics. Investment costs should be treated as capital expenditures even when performed by in-house counsel.
Employee salary is a direct inventory cost if the asset being improved by the labor is property held for sale to customers — that is, inventory. When the asset is held for investment, the asset is not called inventory. Still, in the calculation of net income, one can no more ignore the costs of employee labor as a part of costs than one can ignore direct labor costs as a cost of production.
Some of the costs subsidized by the expensing rule are not meritorious. Subprime mortgages, for instance, collapsed, and that was the starting cause of the recession. Expensing of the in-house costs of pooling subprime mortgages is part of the cause of the overextension of capital into subprime mortgages. Expensing should not be used to subsidize those activities, because the budget techniques in evaluating the tax subsidy from expensing are nonexistent. Tax especially should not subsidize dubious, risky, overextended investment as happened when the in-house activities of pooling subprime mortgages were expensed.
The rule allowing expensing of employee and partner compensation also invites manipulation. If the business will make outside counsel a temporary employee or partner, the same fees will become expensable. The regulations attempt to establish a distinction, between employee work and outside work, that will lead to significantly different results in transactions that have the same economic substance. The distinction will be hard to maintain because it is so easily crossed over.
The proposal of the last segment would expand the capitalization of costs of a corporate acquisition or contract to include the costs of investigation and consideration before the transaction is close to finalization. For both the contracts (paragraph 263(a)(5)) and acquisitions (paragraph 263(a)(4)), capitalization under this proposal would include direct and indirect costs of investigating and considering the transaction, including compensation paid to outsiders, employees, board members, and the taxpayer’s partners.
c. Contracts are capital assets. The regulations provide that costs of certain contracts need to be capitalized, including, for example, the costs of creating financial instruments, leases, and compensation agreements. But the regulations then create a general rule that the costs of creating (or renewing) a contract that is not specified are not considered to be a separate and distinct asset and hence do not need to be capitalized. The proposal (paragraph (5)) would capitalize the costs of multiyear contracts as a general rule and not just for the specified kinds of contracts.
The regulations capitalize the costs of making or acquiring a separate and distinct asset that is protected by property law, provided the asset is capable of being sold apart from the sale of the business as a whole.
Contract law protects a taxpayer’s rights to future cash flows as do the taxpayer’s property rights. Contract rights can be sold or assigned. Rights to cash flows the taxpayer is to receive from a contract are usually assignable, even when there is language in the contract to the contrary, so as to promote alienation of the cash flows.
Sale or assignment of contract-right cash flows is generally as easy as (sometimes easier than) the sale of property rights. Moreover, there is no viable distinction between the quality of the protection offered by legal contract rights and those offered by legal property rights. Principles of capitalization that the intangibles regulations apply to financial instruments, leases, and compensation agreements are applied in equal force to other contracts under the proposal.
d. Contract terminations, in general. Current regulations generally provide that costs paid to a counterparty to terminate a contract are expensed. However, payments made to terminate some contracts, including a lease or a noncompetition agreement, are capitalized. A termination payment that is capitalized is written off over the remaining life of the contract.
The proposal would use the capitalization rule that the intangibles regulations apply to some contracts as the principle applied to all contracts. All costs incurred to terminate a contract would be written off over the remaining term of the contract assuming it had not been terminated. The proposal is parallel to the proposal of the prior section (contract rights as a separate and distinct asset) in expanding application of the capitalization principle from some contracts to all contracts.
Payments made to terminate a contract are capital expenditures made to reduce costs or increase revenue for the period the extinguished contract would have run. Assume, for example, that a college buys out the contract of a football coach because the coach does not have a winning record when the contract has five more years to run. If the college were a taxable entity, the buyout would be a five-year investment capitalized in computing its taxes.
Sometimes the taxpayer pays to get out of the contract because the price the taxpayer is required to pay is too high, given changes in the market or its needs. The taxpayer is better off paying a lump sum now instead of periodic payments required under the contract to buy goods or services. A utility might pay to get out of a long-term contract obligating it to purchase oil or gas because the market prices of oil and gas have dropped. Sometimes the taxpayer pays to get out of the contract because it can get a better price to sell its goods and services elsewhere. A landlord, for instance, might buy out a lease to be able to demolish the building and put up a far taller office building. In either case, the taxpayer paying to get out of the contract is paying a price now to improve its situation, compared with the enforceable contract that is the status quo absent buyout. The remaining years of the bought-out contract makes it simple to determine the life of the termination payments.
What the taxpayer does once the contract is terminated is not a very good indicator of the life of the termination investment. In the preamble to the intangibles regulations, Treasury explained that payments to terminate an existing contract would not be treated as facilitating another transaction because well-advised taxpayers could avoid the rule and only uninformed taxpayers would be caught.
Indeed, if a taxpayer pays to cancel a contract, the life of the replacement arrangement can vary tremendously without much change in the underlying economics. For instance, a utility might pay to get out of a long-term contract obligating it to purchase oil or gas for a set price because the price set in the contract is too high. The utility would then go into the to terminate a contract are expensed. However, pay spot market to buy the oil and gas it needs or enter into an even longer-term contract with greater security. None of the complexities of the replacement decision are necessary to the capitalization decision. Under the proposal, contract termination payments are amortized over the life of the extinguished contract.
e. Ending the prospective-only default rule. The intangibles regulations require capitalization in specified cases if a cost is an investment with substantial future value. The regulations then set out a default or fallback rule allowing expensing for all the unspecified cases of costs with significant future value, until the expensing right is changed. In other words, expenditures with substantial future value that are not specifically covered in the regulations are allowed to be expensed, unless and until Treasury publishes guidance in the Federal Register requiring capitalization. That guidance must be prospective in operation, so that costs incurred before the publication of notice will remain expensed costs.
Costs with substantial future costs are capital expenditures in principle for the purpose of allocating them to future periods in which the benefits from the costs will arise. The fallback rule in the regulations inappropriately freezes results in favor of expensing and excludes audits and judicial proceedings from the decisionmaking process — even when the IRS on audit should assert capitalization of the costs, and a court facing the issue should and would find the expense to be a capital expenditure. The Service is not allowed to issue a revenue ruling stating, after careful consideration on some issue, that it is the IRS’s legal opinion that a cost is a capital expenditure. Treasury cannot issue a notice about abusive transactions concluding that the cost is a capitalized expenditure in the year incurred. No agent can assert capitalization beyond the specified cases, even for clear investment costs. No court will ever hear an argument that the expenditure is capital, even for cases that the government would win.
The genius of the common law is that courts can decide the proper results after consideration of the facts and circumstances of a full record; the American common law system differs from a civil-law system in attitude because the common law is skeptical that justice can be reached on the basis of preset rules. Freezing out the IRS and courts does collateral damage. IRS audits are the eyes and ears of Uncle Sam. The regulations frustrate audits before they start because they can never produce any revenue for Uncle Sam. Thus, the law never finds out about abuses or about the unenumerated cases that need to be capitalized.
If the Financial Accounting Standards Board, for instance, decides that a reporting firm is not required to expense an item when incurred, and capitalization is the generally accepted practice for commercial accounting, that is good evidence that capitalization is worth the effort. The tax law should adapt rapidly and retroactively to adopt that wisdom of capitalization.
The proposed rewritten subsection 263(a) would state, before its list of capitalized expenditures, that ‘‘no deduction shall be allowed for capital expenditures and investments, including, but not limited to’’ the enumerated list. Rewritten subsection 263(b) would list items that do not need to be capitalized. The amendment would require Treasury to repeal reg. section 1.263(a)-4(b)(1)(iv) and (2) requiring publication and prospective effect for capitalization of investments.
f. Package and product design. The current intangibles regulations provide that costs of package design are not capitalized costs. Package design costs are investments that do not expire by the end of the year, and so they are properly capitalized. Product design costs, for instance, are capitalized. In a successful consumer business, no viable distinction can be made between good design for the product being sold and good design for the package it comes in. Package and product design costs should not be considered inventory costs because they benefit not only the stock of items made or acquired during the year, but also items acquired in the future until the product is abandoned or the last vestige of the design is replaced. Package design costs are not meritorious enough to be subsidized by the tax system by way of expensing or with an artificially short life. Design costs do not last perpetually but erode, given the fickle changes of fashion and the fierce competition for consumers’ attention. But they are not expired costs by year-end either. The general or default rule for intangibles that do not last indefinitely is a 15-year life. The proposal, in paragraph (7) of rewritten subsection 263(a), would apply the 15-year life to package and product design.
g. Patents. The regulations treat the costs of obtaining a patent as a research and experimentation cost, expensed under section 174. Similar costs paid to a government agency for a license, copyright, trademark, or other right issued by a governmental agency are capitalized.
The proposal would capitalize the costs of obtaining and defending a patent.
Expensing of R&E costs for tax purposes is best understood as an imitation of nontax accounting, which requires the expensing of research and development.
The primary reason why R&D is expensed, according to FASB, is that ‘‘there is a high degree of uncertainty about the future benefit’’ from R&D and, indeed, studies had failed to find a significant correlation between R&D expenditures and increased future sales or earnings.
Even for successful research, the life of investment is usually difficult to ascertain.
A patent, however, means the taxpayer has achieved an innovation not obvious within the existing state of the art. The cost of obtaining a patent differs from R&E costs within section 174 because the costs are no longer nebulous basic research unattached to a property right, commercial product, or future revenue stream. The costs of a patent attach unambiguously to the patent, which is a separate and distinct asset under the intangibles regulations. The taxpayer’s willingness to pay the costs of obtaining and later defending the patent means that the taxpayer has become convinced that the underlying idea has a future income stream worth the price paid. Patents are available only by application to the patent office, and they last for a 20-year term from the date of application.
Obtaining and defending a patent is an investment to achieve a cash flow from royalties over the next 20 years.
The proposal treats the cost of application for a patent as a capital expenditure with a 20-year life. The costs of defending the patent would be treated as having a life equal to the remaining life of the patent.
3. Repeal of inappropriate statutory expensing. The omnibus capitalization proposal would reverse expensing currently allowed by statute, including the expensing of costs of a crop not harvested until the next year, costs of exploring for and developing oil and gas and other minerals, costs of film and television production, and costs of depreciable property.
a. Farm and planting costs. Under current law, the expenses of planting a crop are deductible when paid.
For most farmers, crops are planted in the spring and harvested in the fall of the same year. It would not then matter whether the costs of a crop are expensed or capitalized because, even if capitalized, the expensing would be allowed against the proceeds from the harvest by year-end. If the harvest is in a different tax year, however, or if the harvest is received by a different taxpayer, the expenses of the crop need to be capitalized to be matched against income from the harvest.
Deductions separated from the related revenue from harvest and sale of the crop because the expenses and revenue are reported in different years or by different taxpayers, do not fairly describe the economic income of the farmer. We can presume that the farmer in planting the crop expects the activity to be profitable because the harvest would more than cover his costs. Some crops produce losses, but we can tell that only when the harvest comes in and is sold and the expenses can be matched against the income which they caused. Expenses not matched against the related revenue from the crop do not reflect the farmer ’s real income.
A series of syndicated tax shelters departed from the farmer ’s ordinary situation and split the year of planting from the year of harvest. The syndication then sold the tax deductions for planting costs, paid for by leverage, as tax losses to high-tax-bracket nonfarmers willing to pay to avoid tax. Congress reacted with a series of antishelter provisions intended to deny nonfarmers the benefits of sheltering, while allowing farmers to continue expensing the costs of planting crops.
The proposal would capitalize planting and fertilization costs when the harvest does not occur in the same tax year and for the same taxpayer in every case. Thus, if the farmer deducts the planting expenses in one year and harvests in the next, the expenses would be matched to the income from the harvest. If the farmer sells the farm after planting a harvest, the planting costs would be part of basis, used against capital gain on sale, and would not be used as an ordinary deduction. If the farmer gives away the crop or gives away the land with unharvested crop on it, the costs of planting would be added to basis for the benefit of the donee. Again, farmers ordinarily would not be affected by the rule because planting and farming occur in the same year. Taking the expenses of the crop as deductions, however, without also taking into income the revenue from the crop at the same time fails to reflect income and is always a per se abuse.
Taking deductions this year for harvests that will not be reported this year gives the equivalent of an exemption for income from the investment. The exemption is more beneficial to the highest bracket farmer than for the middle-income farmer. Indeed, the working and middleincome farmers are hurt by the tax subsidy of expensing because the subsidy induces a higher price for inputs and a lower price for their harvests.
b. Oil and gas. Under current law, a taxpayer may deduct the costs of drilling for oil as if it were a lost cost when made, even if the drilling program is successful.
The deduction arises from a congressional resolution adopted in reaction to a Fifth Circuit decision holding that intangible drilling costs were indeed capital expenditures. Costs eligible for expensing under section 263(c) must be costs that cannot be salvaged when the drilling is over. An integrated oil company must reduce its expensed intangible drilling costs by 30 percent and amortize that 30 percent over five years. In computing alternative minimum tax, the intangible drilling costs are amortized over five years. The deduction creates a tax expenditure estimated to be worth $3.5 billion for 2007-2011.
The proposal would capitalize the costs of drilling for oil and allow recovery of the cost by cost depletion as the oil recovered by the costs is sold. Costs of dry wells would be deducted when the costs expire, but the investment should be defined by an entire program of drilling, rather than individual wells. Regulations would define the program unit, and costs of the entire program would be capitalized even if some of the wells within the program are dry. Costs would be recovered by cost depletion as oil from the program is extracted.
c. Mines and mineral deposits. Section 617(a) allows a taxpayer to deduct the costs of exploring for minerals (other than oil and gas), and section 616(a) allows the taxpayer to deduct the costs of developing a mine or mineral deposit (other than oil and gas). As noted, the expensing was adopted during the Korean War because of concerns about a deficiency in metals and minerals during that ‘‘present emergency.’’ The emergency is over, but the costs of expensing have never been tested by careful budgeting or cost benefit analysis.
The proposal would capitalize the costs of exploration and development of metals and other minerals and allow recovery by cost depletion as tons are extracted.
d. Film and television production. Under section 181, a taxpayer may expense up to $15 million of domestic compensation costs for the production of film and television. Section 181 is scheduled to expire at the end of 2009. Section 181 represents subsidies that would never pass a rational cost benefit analysis or sound budgeting review, and it should be allowed to expire as scheduled. The proposal lists the costs of film and television production as a typical capital expenditure because they are investments, which are not worthless or losses when incurred.
e. Depreciable property expensing. Section 179 now allows a taxpayer to expense $250,000 worth of the cost of depreciable property in the year it is put into service. The expensing is reduced one dollar for every dollar of depreciable property in excess of $800,000. For tax years that begin in 2011, the $250,000 allowance is scheduled to drop to $25,000, and the $800,000 phaseout line is scheduled to drop to $200,000.58
When depreciable property is purchased with debt financing, the taxpayer gets a deduction for interest as well as the expensing. Expensing and the interest deduction are inconsistent as a matter of principle. The combination of the two gives a negative tax or subsidy usually worth 35 percent of the interest costs. Thus, for instance, as a nation we borrow from the Chinese, paying 5 percent interest, and invest in depreciable property giving only 3.25 percent interest in the absence of the tax. The investment puts the country as a whole deeper in debt because the project does not carry its cost of capital. But the private investor is blind to the overall harm because the tax benefits from the combination of expensing and the interest deduction justify the investment from a private point of view. The system should not be subsidizing investments that return less than their capital cost: Money-losing in the absence of tax is a terrible way to identify investments to subsidize, because those investments waste capital.
The proposal would repeal section 179.
4. Nonstatutory expensing: service provider investment. A taxpayer is required to use inventory accounting ‘‘in every case in which the production, purchase or sale of merchandise is an income producing factor.’[’60] Inventory accounting matches costs with the income from the sale of the merchandise that the costs produce. The costs of inventory units the taxpayer has on hand at the end of the year are not deductible until the units are sold or lost. However, service providers who never acquire title to inventory held for sale are immune from capitalization, even if the taxpayer has an investment interest much like that achieved by buying or making inventory. Costs of providing services are sometimes like that of buying or making and selling inventory.
Lawyers, for example, may deduct the costs of a multiyear litigation when the costs are incurred. The lawyer has a reasonable expectation of eventually being paid when the suit is final or settled. The lawyer would not advance the costs except under the expectation that the investment will be justified by future fees. A lawyer’s briefs, motions, and a partially developed suit are not considered inventory held for sale, even though they look very much like work-in-progress inventory. Thus, a plaintiff’s lawyer working on contingency on a lawsuit may deduct the costs of salary of associates and employees, rent, travel, copying, and other costs when incurred, even though those expenses cause and are best matched with the future fees expected from the lawsuit. The expenses are rational investments when made. Under current law, however, the costs of developing litigation are not treated as capitalized investment costs because the lawyer has nothing amounting to inventory.
Deducting investment costs related to future income fails to reflect the income from the enterprise.
Taxpayers also manipulate the expensing allowed for service providers. For example, film and television production is often financed by denying investors an ownership interest in the completed film. Their investments are then treated as service-provider costs, immune from capitalization. Often the ‘‘employment agreement’’ provides for ‘‘compensation’’ that is contingent on the box office receipts, but the reporting position is that the contingent interest is not tantamount to ownership of an inventory property. The theory is that the costs are not capitalized because the taxpayer is merely a service provider who has no interest in the film. Regardless whether the compensation, contingent on the success of the production, amounts to an interest in property, the investor is still making an investment that is rational because it is based on the expectation of future returns. Given that expectation, the expenses are not losses when made. Deduction of the investment costs of a production before the related income has been taken into income is accounting that does not reflect the income of the enterprise.
The proposal would capitalize direct and indirect costs of providing services when fees of a litigation or legal project are reasonably expected to exceed $1 million. If the fees are contingent, for instance, on litigation success, they will be considered to be worth $1 million if the lawyer’s share of a successful suit under the complaint is greater than $1 million and the costs exceed $400,000 a year. The high threshold is intended to identify cases in which the expensing is especially abusive and cases in which deferral of the expenses is well worth the effort given the revenue at stake. Ordinarily the meaning of ‘‘project’’ will be set by the employment contract, aggregating related contracts that are part of a single plan. Cost recovery would be cost depletion, allocating the cost to the total fees expected from the contract De minimis expenses are those too small to be worth the effort of accounting for correctly. Current regulations treat $5,000 as de mininis. As time goes by, accounting is becoming cheaper because the computer programs get better and cheaper. With improved technology, the accounting involved is worth the tax revenue at stake at lower levels. The proposal is to reduce the de minimis rule by 10 percent a year, but the issue can be handled by regulations. The regulation writers might well decide, appropriately, that the extra burden of capitalization is trivial in a computerized system and eliminate the de minimis rule. From my own point of view, I would expect that the extra burden of capitalization within a computerized system is always too small to measure, but I would allow that decision to be made by regulations after study of the issue.
The line, now at $5,000, should also be tested by aggregating all the items in a single package, pool, or plan. Suppose, for example, a taxpayer buys 10,000 fungible parts at $100 a piece. Because each part has the same depreciable life, there is no need to disaggregate the overall $1 million purchase into $100 parts. A single journal entry and a single ledger account will cover the purchase. When the package could reasonably be posted to a single ledger account, the entire entry needs to be treated correctly. It is important that a de minimis rule not encourage needless disaggregation of a plan or a package that can be handled as a whole. Thus, de minimis costs would be rare, only for isolated purchases in which ordinary business books would not cover the costs units larger than $5,000. Substance, not form, will determine whether the purchase is part of a single plan or package or ledger account.
5. Exceptions to capitalization: de minimis. The proposal would use subsection (b) of section 263, which is not now in use, to describe costs that do not need to capitalized. The list would not be exhaustive, allowing cases in which a cost is not truly an investment and has expired by the end of the year. The new subsection would include a discussion of de minimis costs.
Alan Gunn, ‘‘The Requirement That a Capital Expenditure Create or Enhance an Asset,’’ 15 B. C. Indus & Comm. L. Rev. 443, 450 (1974).
The principle that expensing is systematically equivalent to exemption of the subsequent income is sometime called the Cary Brown thesis. Cary Brown, ‘‘Business-Income Taxation and Investment Incentives,’’ in Income, Employment and Public Policy: Essays in Honor of Alvin H. Hanson, 300 (1948). See, e.g., Calvin H. Johnson, ‘‘Soft Money Investing Under the Income Tax,’’ 1989 Ill. L. Rev. 1019 (1990), for one lawyer’s explanation. Expensing is better than exemption if rates drop or if the revenue is tax advantaged (e.g., capital gain), even if taxable
INDOPCO Inc. v. Commissioner, 503 U.S. 79, 84, 112 (1992).
Hertz Corp. v. United States, 364 U.S. 122, 126 (1960).
Idaho Power v. United States, 418 U.S. 1, 16 (1974).
See, e.g., Johnson, ‘‘Tax Shelter Gain: The Mismatch of Debt and Supply Side Depreciation,’’ 61 Tex. L. Rev. 1013 (1983).
Johnson, ‘‘The Effective Tax Ratio and the Undertaxation of Intangibles,’’ Tax Notes, Dec. 15, 2008, p. 1289, Doc 2008-24799, or 2008 TNT 242-46.
Stated algebraically, a borrowed amount B justifies a grossed-up investment of B/(1-T), which T is now tax rate. The investment generates a pretax return of R and bears interest costs of B*I where I is the interest rate, generating an annual profit of B/(1-T)*R B*I and an after-tax profit of [B/(1-T)*R B*I ] * (1-T) or B*R B*I*(1-T). A break-even investment occurs when B*R B*I*(1-T)=0 orR= I*(1-T). With interest at 5 percent and tax rates at 35 percent, the break-even R is 65 percent of 5 percent, or 3.25 percent. The algebra is further explained and defended in the article cited at note 7 supra.
INDOPCO, 503 U.S. at 84 n. 4 (1992).
Hearings on H.R. 4473 Before the Senate Committee on Finance, 82d Cong., 1st Sess. 1179, 1180 (1951) (prepared statement of Henry B. Fernald).
Quoted in Gail Bassenger, ‘‘Taxes,’’ in A Critical Dictionary of the French Revolution, 589 (Francois Furere and Mona Ozoup, eds., 1991).
Section 263(a) (improvements and betterments) and (a)(2)(restoration).
Johnson, ‘‘Simplification by Repeal of the One-Year Rule for Prepayments,’’ Tax Notes, Aug. 24, 2009, p. 809, Doc 2009-17548, 2009 TNT 161-11.
INDOPCO, 503 U.S. 79.
Reg. section 1.263(a)-5(e)(1).
 Charles T. Horngren et al., Introduction to Managementm Accounting, (9th ed. 1993); Gapol Ramon, Accounting for Managers, 485-486 (2009).
Libson Shops v. United States, 55-1 USTC para. 9458 (D. Mo. 1955), aff’d on other issues, 229 F.2d 220 (8th Cir. 1956), aff’d, 353 U.S. 382 (1956).
Ellis Banking Corp. v. Commissioner, 688 F.2d 1376, 1382 (11th Cir. 1982).
Reg. section 1.263(a)-4(e)(1)(iii).
Reg. section 1.263-4(c)(3).
Reg. section 1.263-4(e)(4)(ii)(b).
Reg. section 1.263-4(e)(4).
Compare reg. section 1.263-4(e)(5), examples 7 and 8.
Commissioner v. Idaho Power Co., 418 U.S. 1, 13 (1974) (emphasis added).
Adolph Coors Co. v. Commissioner, 519 F.2d 1280 (10th Cir. 1975) cert. denied, 423 U.S. 1087 (1976) (deduction of employee salary and overhead costs allocable to construction of building and machinery to expand the brewery did not reflect income; costs needed to be capitalized); Acer Realty Co. v. Commissioner, 132 F.2d 512 (8th Cir. 1942) (salaries of employees and officers spent on construction of building in house were capital ex-penditures); Perlmutter v. Commissioner, 44 T.C. 382 (1965), aff’d, 373 F. 2d 45 (10th Cir. 1967) (officer’s salary was part of overhead allocated to acquisition of shopping mall); Chevy Chase Motor Co. v. Commissioner, T.C. Memo. 1977-227 (salary of presidentshareholder of real estate development firm capitalized to the extent of time spent supervising construction).
Wells Fargo v. Commissioner, 224 F.3d 874 (8th Cir. 2000), Doc 2000-22578, 2000 TNT 169-18.
Thus, for example, Idaho Power Co., 418 U.S. 1, upheld capitalization of the depreciation on equipment and would have required capitalization of depreciation on buildings and factories allocated to the project.
See, e.g., reg. section 1.471-3(c)(2) and (3) (1993) (inventory costs include direct labor and indirect overhead costs).
Reg. section 1.263(a)-4(d)(2) (financial instruments) and (d)(6) (leases and compensation agreements).
Reg. section 1.263(a)-4(b)(3)(ii).
Reg. section 1.263(a)-4(b)(1) and (3).
See, e.g., American Law Institute, ‘‘Restatement (Second) of Contracts,’’ section 322(1) (2009): ‘‘Unless the circumstances indicate the contrary, a contract term prohibiting assignment of ‘the contract’ bars only the delegation to an assignee of the performance by the assignor of a duty or condition’’ and not the assignment of the cash flows.
Reg. section 1.263-4(b)(3)(ii) and -(e)(5), Example 2. Reg. section 1.263-4(d)(6)(vii), examples 4 and 5, reinforce the rule by providing that contract-termination payments set by the contract itself and payments to change the termination payment amount are not capitalized.
Reg. section 1.263-4(d)(7).
Reg. section 1.263-4(f)(2).
T.D. 9107 (para. E.1).
Reg. section 1.263-4(b)(1)(iv) and (2) (publication and prospective effect).
Commissioner v. Idaho Power Co., 418 U.S. 1, 16 (1974); Hertz Corp. v. United States, 364 U.S. 122, 126 (1960).
Reg. section 1.263(a)-4(b)(3)(v) and -(l), Example 9.
Robinson Knife Mftg Co. v. Commissioner, T.C. Memo. 2009-9, Doc 2009-827, 2009 TNT 9-19.
Reg. section 1.167-3(b)(1).
Reg. section 1.263-4(d)(5).
Accounting for Research and Development Costs, Statement of Financial Accounting Standard No. 2, para. 49 (1974) (requiring the immediate expensing of R&D costs).
Id. at paras. 39, 41 (1974). Johnson, supra note 2, at 1078, argues that section 174 was, in fact, adopted primarily in reaction to an erroneous argument by the IRS commissioner that capitalization did not make any difference after the transition period.
35 U.S.C. section 103(a), providing that a patent may not be obtained for a invention if the invention would have been obvious to a person having ordinary skill in the state of the art at the time of the invention. See, e.g., Annotation, Application and effect of 35 U.S.C.A. section 103, requiring nonobvious subject matter, in determining validity of patents, 23 A.L.R. Fed. 326 (1975 with online supplements).
35 U.S.C. section 154.
Section 180 (1988); reg. section 1.162-12 (1973).
See, e.g., Johnson, supra note 2, at 1023-1029.
See, e.g., section 263A(d)(1)(B) and (d)(3)(B) (denying shelters and agribusiness exemption from ‘‘full absorption’’ capitalization rules); section 447(b) (putting ‘‘agribusiness’’ but not small family corporations on accrual method); section 464(a)(denying tax shelters deductions for prepaid farm supplies); section 461(i)(1) (denying tax shelters the recurring items exemption from economic performance limitations); section 469(c)(1)(B) (exempting individual from passive loss limitations on activity in which individual materially participates).
F.H.E. Oil Co. v. Commissioner, 147 F.2d 1002 (5th Cir. 1945), reh’g denied, 149 F.2d 238 (1945), second reh’g denied, 150 F.2d 857 (1945). See Boris I. Bittker and Lawrence Lokken, ‘‘Federal Taxation of Income, Estates and Gifts,’’ para. 26.1.1 (2009).
Harper Oil Co. v. United States, 425 F.2d 1335 (10th Cir. 1970) (Blackmun, J.) (drilling casings held not intangible drilling cost); Standard Oil Co. v. Commissioner, 77 T.C. 349 (1981) (accord); Exxon Corp. v. United States, 547 F.2d 548 (Ct. Cl. 1977) (construction of offshore platforms held not intangible drilling cost).
Sections 56(g)(4)(D)(1) and 312(n)(2)(A).
Joint Committee on Taxation, ‘‘Estimates of Federal Tax Expenditures For Fiscal Years 2007-2011,’’ (JCS-3-07), at 47, Doc 2007-21689, 2007 TNT 186-12.
See supra text accompanying note 10.
Section 179(b)(1) and (2).
See supra note 7; Johnson, ‘‘Pretty Cruddy Investments Brought to You by Stimulus Depreciation,’’ Tax Notes, Feb. 11, 2008, p. 731, Doc 2008-1869, or 2008 TNT 29-41.
Reg. section 1.471-1.
Reg. section 1.263(a)-4(e)(4)(iii).
Reg. section 1.263(a)-4(d)(vi), Example 10, allows expensing of a $300 cell phone given to customers for signing up for multiyear telecommunications contracts. But with, for example, 10,000 customers in a year and purchase of the cell phone from one supplier, the cost of the total package of cell phones would be $3 million, or more than enough to capitalize.
Previously published by the University of Texas – School of Law, September 2009