By Professor Glenn Walberg
University of North Carolina at Wilmington, Wilmington, NC
Despite recent efforts to ease the administrative burdens of determining which costs businesses may deduct, practitioners must still navigate complex sets of rules in distinguishing deductible business expenses from nondeductible capital expenditures. Final §263 regulations have attempted to clarify capitalization principles by generally requiring capitalization for only those costs described in the regulations. However, as aptly illustrated by PLR 201032023 (8/13/10) inclusion of multiple descriptions of potentially capitalizable costs in the regulations makes it prudent for a practitioner to address capitalization issues methodically and carefully.
The PLR addressed the deductibility of amounts paid by an investment advisor to marketing agents in connection with promoting investments in funds formed by the advisor. Each fund engaged the advisor to provide investment advisory services in exchange for a fee computed as a percentage of the fund's net assets, and each fund employed underwriters to offer the fund's shares to the public. The advisor then engaged some of the underwriters to act as marketing agents that would attempt to increase demand for investments in the fund by promoting the advisor's investment strategy for that fund. The advisor paid the marketing agents in arrears for their services either in accordance with the marketing agreements or separate termination agreements. None of the payments were made on behalf of the investment funds; instead, the advisor benefited from the marketing efforts insofar as greater investments in the funds produced a larger fee payable for its investment advisory services.
In considering the deductibility of the payments made to the marketing agents, the IRS considered whether the costs were (1) capitalizable as amounts paid to create or enhance of a separate and distinct intangible asset or paid to create (or facilitate the creation) of an intangible under Regs. §1.263(a)-4 or (2) capitalizable as amounts paid to facilitate a stock issuance under Regs. §1.263(a)-5. The ruling thus considered multiple ways in which the costs might be capitalized under the regulations.
The IRS first concluded that the advisor did not pay the amounts to create or enhance a separate and distinct intangible asset. The regulations define a "separate and distinct intangible asset" as a property interest of ascertainable and measurable value, where the interest is subject to legal protection and the possession and control of the interest is intrinsically capable of being sold, transferred, or pledged separate and apart from a trade or business. Although the marketing agreements arguably satisfied this definition, the IRS focused on a different provision that excludes from this definition agreements that produce rights or benefits for a taxpayer. In this situation, the IRS concluded that the marketing services produced rights or benefits for the advisor and thereby kept the payments outside this capitalization rule.
The IRS then considered whether the payments nevertheless created an intangible. In considering the possible application of three separate rules, the IRS concluded that the payments did not fit within any of the three descriptions of capitalizable costs. In particular, the IRS noted that: (1) the making of payments in arrears precluded their characterization as capitalizable prepaid expenses; (2) the exchange of the payments for the services previously rendered kept the payments from constituting a capitalizable amount paid to create, originate, or enter into an agreement that would entitle the advisor to receive future services; and (3) the payments were not made with respect to terminating a lease, exclusivity agreement, or non-compete agreement for which the regulations require capitalization.
Finally, the IRS concluded that the payments did not facilitate the creation of an intangible within the meaning of Regs. §1.263(a)-4. The IRS considered that the relevant intangible, for purposes of considering this capitalization rule, would have been the advisory services agreement. But the IRS concluded that the marketing payments were not paid to investigate or otherwise pursue the advisory services agreement because the terms of the agreement were not conditioned on advisor's engagement of the marketing agents and the marketing agreements were executed after the advisory services agreements.
The IRS then addressed the question of whether the payments were capitalizable under the separate rules of Regs. §1.263(a)-5 as amounts paid to facilitate a stock issuance. The IRS described how, under general case law, capitalizable stock issuance costs offset issuance proceeds. With that background, the IRS explained that capitalization was not appropriate in this situation because the funds, rather than the advisor, issued the stock so the payments could not represent the advisor's cost of securing capital. The IRS further noted that the marketing payments were not directly incurred as a result of the registration, issuance, or redemption of stock and, as such, were not properly capitalizable. The IRS thus walked through numerous rules under Regs. §1.263(a)-4 and -5 to determine the deductibility of the marketing payments.
PLR 201032023 is noteworthy, in part, for its detailed examination of lots of capitalization rules in determining the deductibility of business costs. The ruling helps illustrate how—despite the arguably clarified approach taken by the regulations—some of the ways in which the capitalization regulations could apply are not obvious. As a result, a practitioner cannot simply focus on a single rule that s/he feels might apply. Instead, questions about capitalization demand that practitioners remain familiar with varied concepts and nuances contained in the regulations and that practitioners consider how many different rules could potentially apply.
For more information, in BNA's Tax Management Portfolios, see Maule, 504 T.M., Deduction Limitations: General, and in Tax Practice Series, see ¶2010, Overview of Deductions, and ¶2920, Capital Expenditures.
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