To Capitalize or Not to Capitalize--The First Question in the
Amortization Puzzle
By Annette Nellen,
Professor
San José State University, San José, CA. Professor Nellen is also a Fellow at the New America Foundation, Washington, DC.
In dealing with amortization of intangibles, it is important to
review not only the amortization rules of §§167 and 197, but
also the capitalization rules of §263 and Regs. §1.263(a)-4
and -5. The final capitalization regulations, published in 2004,
provide some welcome guidance that can sometimes simplify amortization
issues, such as where the rules provide that an amount producing
intangible benefits is not required to be capitalized. In other
situations, the regulations make it clear that an amount must be
capitalized, leaving it to the taxpayer to determine whether
amortization is possible, and if so, which amortization provisions
apply.
The guidance on amortization under §§167 and 197,
separated from the later guidance under §263(a), pose some areas
of uncertainty for taxpayers and their tax advisers because these
related sets of rules are explained separately. Also, some rulings
that were issued prior to the release of the §263(a) regulations
in 2004 may be outdated and there are no official rulings yet under
the 2004 capitalization regulations.
An example of a simplification provided by the final §263(a)
regulations involves the fact pattern of TAM 9544001 (7/21/95) which
involved the treatment of costs to reconfigure manufacturing
facilities and train personnel to adopt just-in-time manufacturing
(JITM). JITM was defined as a “radical redesign of existing
manufacturing processes” that eliminated waste, added
flexibility, allowed existing equipment to be used more efficiently
and even per statements made by the taxpayer, would provide long-term
benefits. The implementation costs included costs for moving existing
equipment; electrical and plumbing modifications; materials and
supplies, such as signs with a useful life extending beyond one year;
employee training at all levels; costs to develop JITM training
manuals and videos; and costs of a consultant.
While the IRS acknowledged that moving and employee training costs
were generally deductible under §162, exceptions existed and each
situation had to be “judged on its particular facts and
circumstances bearing in mind that distinctions between current
deductions and capital expenditures are often a matter of degree and
not of kind.” The IRS held that the cost of physically
reconfiguring Taxpayer's facilities had to be capitalized because the
overall plan to change to JITM was a long-term proposition. The IRS
also noted that while costs to increase future operating efficiencies
were not capital per se, such a benefit was to be taken into account
in distinguishing capital expenditures from ordinary ones.
In the TAM, the IRS also ruled that the materials and supplies were
capitalizable because the items were not consumed during the year or
consumed in the manufacturing process. Costs to produce training
manuals were held to be capitalizable even if continuously modified.
The IRS also held that the employee training costs were capitalizable,
in part, based on Cleveland Electric Illuminating Co. v. U.S.,
7 Cl. Ct. 220, 234 (1985), which involved training utility company
employees to operate a nuclear power plant where only a coal plant was
used before. The IRS did acknowledge though, that ongoing training
costs would fall under §162.
The question that remained after the TAM was whether any of the
capitalized amounts could be amortized and if so, under what life and
method. Since it would be difficult to demonstrate a useful life for
the costs of converting to JITM processes, it was likely that none of
the costs could be amortized or otherwise written off unless they met
the definition of a §197 intangible or could be treated as an
inventoriable cost under §263A.
With the issuance of Regs. §1.263(a)-4 (T.D. 9107, 69 Fed.
Reg. 435 (1/5/04)), the lingering amortization issues that TAM 9544001
raised were resolved because the regulations do not require business
process reengineering costs to be capitalized. Under Regs.
§1.263(a)-4, reengineering costs related to implementation of the
process reengineering, relocation and reconfiguration of an assembly
line, and related training costs are not treated as incurred to
acquire or create an intangible or to facilitate such acquisition or
creation. Thus, the costs do not have to be capitalized (Example 5 of
Regs. §1.263(a)-4(l)). Thus, it is important to review the
§263(a) regulations rather than assume that you just have an
amortization question when dealing with an expenditure with long-term
traits.
On the other hand, some of the rules and examples of the
§263(a) regulations raise questions because it is not clear if
some amounts required to be capitalized under the regulations are
amortizable and the regulations only address capitalization.
Consider Example 1 of Regs. §1.263(a)-4(d)(4)(ii), where a
doctor pays a fee to a hospital to obtain lifetime staff privileges at
the hospital. Regs. §1.263(a)-4(d)(4) provides that this fee is
for the creation of a privilege and is required to be capitalized. The
next question is whether the amount is amortizable--an issue that is
not addressed in the same regulations. Instead, §§167 and
197 and the regulations thereunder must be reviewed. The capitalized
fee is not a §197 intangible due to the exception at
§197(e)(4)(B) and Regs. §1.197-2(c)(6) for any rights to
receive services under a contract that is not acquired as part of a
purchase of a trade or business. That regulation refers to Regs.
§1.167(a)-14(c)(1) and (3) for further guidance. However, because
this right is for an unknown period and does not call for a fixed
amount of services to be received, that regulation does not provide an
answer regarding amortization of the capitalized fee.
In Sharon v. Comr., 66 T.C. 515 (1976), aff'd, 591
F.2d 1273 (9th Cir. 1978), cert denied, 442 U.S. 941
(1979), the court allowed an individual who acquired a professional
privilege lasting for the individual's lifetime to use life expectancy
as the useful life for amortization purposes. If the doctor is only
recently out of medical school when the hospital privilege is
obtained, the useful life for the capitalized amount would be well
over 15 years. If this life expectancy approach is not viewed as an
estimation with reasonable accuracy, the doctor may instead be able to
use a 15-year life and the straight line method per the safe harbor
amortization rule of §1.167(a)-3(b)(1). This is an area in need
of guidance.
It appears that Congress and the IRS are attempting to confine most
amortizable intangible assets to a 15-year life given changes to
§195 and §248 by the American Jobs Creation Act of 2004
(P.L. 108-357) and the safe harbor at Regs. §1.167(a)-3(b) that
was added at the same time the §263(a) regulations were finalized
(T.D. 9107, 69 Fed. Reg. 435 (1/5/04)). However, there are still
situations of uncertainty, as with the hospital privilege example,
where the useful life for amortization purposes is not obvious.
If the examples in the §263(a) regulations had also specified
the amortization treatment, there would be greater certainty in the
amortization area. Instead, we will likely have to wait until such
issues are addressed in letter rulings or case law. In the meantime,
it is important to begin the resolution of questions involving
expenditures that produce intangible benefits with Regs.
§1.263(a)-4 and -5. Where an amount is required to be
capitalized, the statute and regulations under §§167 and 197
must then be considered. In some situations, tax preparers may find
that they do not meet the more likely than not standard of §6694
and will have to disclose the position taken to avoid the imposition
of a preparer penalty.
For more information, in the Tax Management Portfolios, see
Nellen, 533 T.M., Amortization of Intangibles, and in Tax
Practice Series, see ¶2380, Amortization of Intangibles.
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