E&Y Comments on Proposed Regs on Capitalizing Costs of Intangibles

[1] Ernst & Young LLP respectfully submits the attached comments regarding changes in methods of accounting for transaction costs under Prop. Treas. Reg. § 1.263(a)4(o)(2), Guidance Regarding Deduction and Capitalization of Expenditures, 67 Fed. Reg. 77,701 (proposed December 19, 2002). These comments reflect our clients' concerns about unintended consequences of the final regulations on the treatment of transaction costs.

[2] Our comments reflect two areas of concern. First, the proposed capitalization regulations suggest that a taxpayer's prior treatment of transaction costs signifies that the taxpayer adopted a method of accounting for those costs. We believe current law does not support the suggestion that a taxpayer's treatment of its transaction costs meets the definition of an accounting method. Second, the proposed capitalization regulations, if finalized, would effect accounting method changes on a modified cutoff basis, which would deny a section 481(a) adjustment with respect to costs paid or incurred prior to the effective date of the final regulations. Although we seriously question whether capitalization is a method of accounting, if the final regulations conclude that any change in the treatment of transaction costs is a change in method of accounting, we believe a section 481(a) adjustment is appropriate and required, without regard to when transaction costs were paid or incurred. Method changes effected on a modified cut-off basis are appropriate, if at all, only to the extent a taxpayer changes to an accounting method that is not available under existing law.

Capitalization as a Method of Accounting

[3] The proposed capitalization regulations imply that the capitalization of transaction costs constitutes a method of accounting but do not provide any clarifying guidance about what constitutes a method of accounting. Further, the proposed regulations do not define what is an "item" in this context; i.e., individual cost categories, such as investment banking fees; types of costs, such as investigatory costs; or costs incurred in a single transaction. The Treasury Department and Internal Revenue Service have indicated that forthcoming guidance will describe what constitutes a method of accounting.¹ Prior to the issuance of such guidance, however, the proposed capitalization regulations reference the need to change methods of accounting to comply with the final regulations, which suggests that the capitalization of transaction costs might constitute a method of accounting. Neither the proposed capitalization regulations nor the accompanying preamble explain the rationale underlying the accounting method reference in the proposed regulations. That omission glosses over the question of whether capitalization by itself (capitalization without depreciation or amortization) constitutes a method of accounting. For example, the proposed regulations assume that a change from capitalizing transaction costs to the basis of stock to currently deducting them involves a change in method of accounting. To suggest in these regulations that the treatment of transaction costs is a method of accounting is clearly premature.

[4] We question whether section 263(a) has the inherent timing aspect necessary for capitalization to constitute a method of accounting. Every method of accounting determines "when" to recognize items of income or deduction. The mere capitalization of any transaction costs under section 263(a) does not readily establish when a taxpayer recognizes those costs as a deduction. Section 263(a), in the context of transaction costs, merely determines "whether" a deduction is appropriate at the instant the costs are paid or incurred. In the decade since the Supreme Court decided INDOPCO, Inc. v. Commissioner,² the Treasury Department and the Internal Revenue Service have not articulated whether or why the capitalization of transaction costs might constitute a method of accounting. Without addressing these significant issues and concerns, it seems inappropriate to summarily conclude that the treatment of transaction costs is a method of accounting in the section 263(a) regulations.

[5] Moreover, one of the hallmarks of a method of accounting is that the item does not affect the lifetime income of a taxpayer. The timing aspect generally relates to when a taxpayer may take a deduction in the ordinary course of its business. With transaction costs for which there is no recovery, these amounts are recovered, if at all, in the moments before the taxpayer goes out of existence. We do not believe the Treasury Department and Internal Revenue Service mean to suggest that the deduction of capitalized transaction costs in the last moments of a taxpayer's life may be considered deductions taken in the ordinary course of business. Yet, this is the result of the proposed regulations. Such a deduction would certainly be considered an extraordinary event. It is important to note that by indicating that the treatment of transaction costs is a method of accounting, the Treasury Department and Internal Revenue Service are dramatically expanding the scope of accounting methods. Under this approach, every item disposed of by a taxpayer could be considered a method of accounting.

[6] Further, if capitalization of transaction costs is indeed a method of accounting, no guidance has been provided as to the "item" subject to such a method. In this context, what constitutes a "transaction cost"? Costs such as salary costs, debt-related costs, advertising costs, and training fees are often incurred concurrent with a transaction. It is not unusual for our clients to incur costs from as many as one hundred vendors during the course of a capital transaction. We! are aware of examining agents who consider all costs listed in a transaction-based general ledger account to constitute an "item" to which a single method of accounting applies. We believe that the inclusion of an individual cost, such as advertising costs, in a general ledger account does not establish a taxpayer's method of accounting for that cost.

[7] In light of these unresolved questions, it is clearly premature to suggest in regulations that a change in the treatment of transaction costs is a method of accounting. We recommend clarifying in the final regulations that the accounting method rules are not intended to imply that a taxpayer's prior treatment of transaction costs represents the adoption of a method of accounting with respect to those costs, and likewise, that the continued capitalization of a transaction cost does not represent the adoption of a method of accounting. Without such clarification, the final regulations would encourage taxpayers to file countless method change requests to protect against potential future claims that those taxpayers changed a capitalization method of accounting without consent.

Section 481(a) Adjustments

[8] The proposed regulations provide that the capitalization rules would apply to amounts paid or incurred on or after the date the final regulations are published in the Federal Register. Moreover, the regulations provide that any change in method of accounting to comply with the regulations must be made using an adjustment under section 481(a). However, the adjustment under section 481(a) is determined by taking into account only amounts paid or incurred on or after the date the final regulations are published in the Federal Register. Thus, the regulations suggest that any change in a taxpayer's treatment of transaction costs is a change in method of accounting and that a section 481(a) adjustment is required only with respect to amounts incurred after the regulations are finalized.

[9] If the Treasury Department and the Internal Revenue Service ultimately conclude that a change in the treatment of transaction costs constitutes an accounting method change, or if they determine that they will treat it as a method of accounting, we believe a section 481(a) adjustment should account for transaction costs paid or incurred prior to the effective date of the final regulations. In addition to following the general statutory requirement for such an adjustment, this approach would avoid inadvertently rewarding taxpayers that deducted all transaction costs or penalizing taxpayers that incorrectly capitalized transaction costs in prior taxable years. By denying a section 481(a) adjustment for all costs paid or incurred prior to the effective date of the final regulations, the final regulations effectively would condone overly aggressive positions assumed in prior taxable years when ambiguity existed in this area. That result is undesirable from a policy perspective because it encourages taxpayers to exploit ambiguous tax provisions. More importantly, by prohibiting an adjustment to properly reflect the change in a taxpayer's method of accounting, the final regulations would effectively require those taxpayers to remain on an improper method of accounting.

[10] Further, if the regulations are finalized as proposed, and if changes to comply with the proposed regulations are treated as a change of accounting method, it is not clear which changes would be made to comply with the regulations and which changes would be made simply to conform to existing law in order to clearly reflect income. Although the proposed regulations purport to interpret existing law, those regulations explicitly reference only a taxpayer's attempt to comply with the final regulations as a change in method of accounting that is effected on a modified cut-off basis. That reference infers that taxpayers also might change methods of accounting to comply with existing law. For example, pending method change applications are grounded in existing law rather than the proposed regulations. The proposed regulations suggest disparate treatment for method changes under the regulations, that is, changes made to comply with existing law would be made with a section 481(a) adjustment, and changes made to comply with the regulations would require a section 481(a) adjustment only to the extent that costs are paid or incurred on or after the effective date of final regulations. Alternatively, the modified cut-off approach of the proposed regulations might suggest that the limitation on a section 481(a) adjustment applies only to method changes that were not clearly established under existing law (e.g., changes associated with the de minimis rule or safe harbors). If the final regulations incorporate this modified cut-off approach, then further clarification is required to address these issues.

[11] Therefore, we suggest that the Treasury Department and the Internal Revenue Service consider adopting a rule permitting taxpayers to compute a section 481(a) adjustment, for taxable years in which taxpayers have retained adequate documentation, which takes into account transaction costs paid or incurred prior to the effective date of the final regulations. Any section 481(a) adjustment should at least include costs paid or incurred during every open taxable year. Concerns about placing substantial computational burdens on taxpayers with respect to a comprehensive section 481(a) adjustment may be alleviated by giving taxpayers a choice to effect the accounting method change with the use of a section 481(a) adjustment for which they have required documentation.

[12] We hope you find the attached comments helpful in formulating the final regulations. Please contact me directly at (202) 327-6305 if you wish to discuss these comments in more detail.

²503 U.S. 79 (1992).

I. The Proposed Capitalization Regulations Infer That the Capitalization of Transaction Costs is a Method of Accounting Despite the Lack of a Requisite Timing Aspect and Without Clarifying What Items are Subject to Such Method of Accounting.

[16] That clarification would maintain consistency within the proposed capitalization regulations. The proposed rules for transaction costs never state that the general capitalization requirements are methods of accounting. In fact, with respect to transaction costs, the proposed capitalization regulations only describe average cost pooling under the de miminis rule as a method of accounting.¹ The lack of comparable descriptions for the general capitalization requirements suggests that a taxpayer would not necessarily adopt or change a method of accounting when attempting to comply with the final regulations. As discussed below, that suggestion reflects current law, which we believe does not treat the permanent capitalization of transaction costs as a method of accounting. Thus, a taxpayer's capitalization of transaction costs in compliance with the final regulations will not necessarily indicate the use of a method of accounting and any determination about whether a taxpayer must adopt or change a method of accounting to achieve that compliance must be made on a case-by-case basis. For example, assuming a taxpayer had deducted a particular "transaction code" in prior taxable years, if capitalization does not represent a method of accounting, then the change in treatment will not constitute a method change because the taxpayer has not changed to a method of accounting. Therefore, the final regulations should clarify that, even though a taxpayer might change a method of accounting to comply with the final regulations, no inference is intended with respect to whether a taxpayer had adopted a method of accounting with respect to transaction costs.

[18] In contrast, a determination of the manner in which a taxpayer takes transaction costs into account would not constitute a method of accounting.⁵ A taxpayer would follow various capitalization rules to determine whether the taxpayer may deduct transaction costs.⁶ Because that determination would affect the taxpayer's lifetime income by establishing whether the taxpayer could ever deduct the transaction costs, the manner in which the transaction costs are taken into account does not affect the timing of any deduction.⁷ The determination of whether transaction costs are deductible is clearly distinguishable from the determination of the correct taxable year for which the deduction would be allowed.

[19] Although no guidance has been issued that directly addresses this point, we believe capitalization under section 263(a) establishes whether a taxpayer can deduct transaction costs but not when those transaction costs are deductible. The treatment of transaction costs under section 263(a) with respect to current law and the proposed capitalization regulations merely establishes whether a taxpayer may deduct transaction costs. If section 263(a) requires the capitalization of transaction costs, then the lifetime income of that taxpayer is affected because section 263(a) has denied a deduction for those costs in any taxable year. Section 263(a) does not merely postpone a deduction to another taxable year; section 263(a) explicitly denies a deduction in every taxable year for transaction costs treated as capital expenditures.⁸ A taxpayer's method of accounting could not simply be described as "capitalization." Therefore, a taxpayer's capitalization of transaction costs does not determine when a taxpayer can deduct those costs and does not represent a method of accounting under either current law or the proposed regulations.

[20] One might view the treatment of transaction costs as a two-step process. First, determine whether a transaction cost is deductible at any point in time. Final regulations under section 263(a) would provide that guidance. Second, establish a method for recovering that amount through deductions in some taxable year. A taxpayer cannot adopt a method of accounting that does not specify when, in the ordinary course of business, a cost becomes deductible. The proposed regulations do not provide guidance on when to recover capitalized transaction costs. Therefore, a taxpayer must look beyond section 263(a) to determine when capitalized transaction costs are deducted.

[22] The implication of capitalizing certain transaction costs under section 263(a) is that a taxpayer's mere capitalization of those costs has not established a method of accounting. Section 263(a) does not allow for any deduction of capital expenditures.

[23] Consequently, a taxpayer's capitalization of transaction costs would not establish a method of accounting because the taxpayer"s treatment of those costs would not establish when the taxpayer could deduct the costs. The deductibility of previously capitalized transaction costs must be determined, if at all, under another Code provision. Any method of accounting for recovering previously capitalized transaction costs would relate to the recovery of such costs under the other Code provision.

[24] If a taxpayer previously capitalized transaction costs but has not used another Code provision to recover the costs, then that taxpayer has not applied a method of accounting for those costs. A taxpayer could not have used a method of accounting for those permanently capitalized transaction costs because the initial capitalization of the costs did not determine when they are recoverable. Despite the possibility that future events might allow a taxpayer to claim a deduction for those costs under another Code provision, the initial determination that the costs were not deductible under section 263(a) did not determine when the costs were deductible as is required to establish a method of accounting.¹¹ A conclusion otherwise would suggest that the capitalization of transaction costs by itself creates an expectation of a future deduction without regard to other Code provisions, which directly contradicts the statutory language prohibiting any deduction for capital expenditures.

[25] The proposed capitalization regulations support the conclusion that compliance with section 263(a) does not establish a method of accounting because that provision only determines whether capitalization is required. The proposed capitalization regulations under section 263(a) carefully word rules in a manner that does not require capitalization for certain transaction costs. The proposed capitalization regulations do not provide a deduction for any costs; instead, in certain instances, they provide that certain amounts are not required to be capitalized (i.e., whenever capitalization is not required under the proposed capitalization regulations, the regulations do not authorize a taxpayer to deduct the paid or incurred Costs).¹² Because a taxpayer will only use the regulations to determine whether certain transaction costs are capitalizable but could not rely on the final regulations as the sole basis to claim a deduction, the final regulations will not determine when a taxpayer may take a deduction for transaction costs. Thus, a taxpayer following the final regulations will not be able to determine when those costs are deductible and therefore will not establish a method of accounting for transaction costs simply by following those regulations.

II. If the Final Regulations Treat the Capitalization of Transaction Costs as a Method of Accounting, a Full Section 481(a) Adjustment is Required for Accounting Method Changes, Particularly With Respect to Changes Consistent With Existing Law, Despite the Modified Cut-off Basis Suggested in the Proposed Capitalization Regulations.

[30] Admittedly, the Commissioner may impose a particular term or condition upon accounting method changes, including effecting such method changes on a cut-off basis.¹⁶ The Commissioner, however, lacks absolute discretion to impose terms and conditions on accounting method changes.¹⁷ In particular, the Commissioner would abuse that discretion by refusing to allow an adjustment, as required by section 481(a), for all accounting method changes under the final regulations. The individual facts and circumstances related to a particular accounting method change must be considered to determine why a section 481(a) is not appropriate for that specific method change.¹⁸ The proposed capitalization regulations, however, suggest that any accounting method change under the final regulations must be made arbitrarily on a cut-off basis. The imposition of that requirement, without regard to individual facts and circumstances, is not a justifiable exercise of the Commissioner's discretion.

[31] The arbitrariness of disallowing any section 481(a) adjustment for costs paid or incurred prior to the effective date of the final regulations is apparent from the requirement to take a section 481(a) adjustment into account under Prop. Treas. Reg. § 1.263(a)-4(o)(2) for costs incurred on or after the effective date of the final regulations. The rationale for denying a section 481(a) should reflect the difficulty of determining the amount of any adjustment, such as from inadequate documentation or from computational complexity, or the promulgation of new rules or standards. Whatever difficulty might arise in connection with changing a method of accounting for costs paid or incurred prior to the effective date of the final regulations, however, would also arise for costs paid or incurred on or after the effective date of the final regulations. Therefore, changes for which a section 481(a) is required should be limited to situations in which new rules or standards for capitalization have been provided. Unfortunately, the regulations do not specify which changes are to be made consistent with the proposed regulation and which changes are consistent with existing caselaw and other guidance. Therefore, as currently drafted, the rules do not minimize controversy but seem to create a new area of dispute, whether a section 481(a) adjustment is available for a particular accounting method change.

[33] If the final regulations follow existing law but do not apply to costs paid or incurred prior to the effective date of the regulations, then an accounting method change to comply with the final regulations arguably represents a change to follow existing law with respect to pre-effective date costs. The proposed regulations presumably would not require taxpayers to remain on improper methods of accounting for taxable years prior to the effective date of the regulations. Therefore, any change in method of accounting for pre-effective date costs should represent conformity with existing law rather than compliance with final regulations.

[34] Although an accounting method change to comply with existing law is not foreclosed by the proposed capitalization regulations, the proposed regulations place undue emphasis on and create potential for controversy over determining whether a taxpayer is attempting to comply with final regulations or conform to existing law. If the regulations are finalized as proposed, and if changes to comply with the proposed regulations are treated as a change of accounting method, it is not clear which changes would be made to comply with the regulations and which changes would be made simply to conform to existing law in order to clearly reflect income. The proposed regulations suggest disparate treatment for such changes. That is, changes made to comply with existing law would be made with a section 481(a) adjustment because costs paid or incurred prior to the effective date of the final regulations are governed by existing law and would remain outside the scope of the section 481(a) adjustment limitation contemplated by the proposed regulations. Whereas changes made to comply with the regulations would require a section 481(a) adjustment only to the extent that costs are paid or incurred on or after the effective date of final regulations. Because these changes both reflect attempts, to change to methods described in the regulations, which primarily interpret existing authority and there has been no statutory change, the regulations should not deny a section 481(a) adjustment for all costs paid or incurred before the effective date of the final regulations.

[38] Alternatively, the final regulations might limit a section 481(a) adjustment to all costs paid or incurred in taxable years for which the statute of limitations continues to run. By limiting a section 481(a) adjustment to a taxpayer's open taxable years, the final regulations would provide more assurance that adequate documentation is retained and that examining agents are more likely to examine the computation.

²The regulations' explanation of a change in a method of accounting indicates the nature of a method of accounting. The regulations provide that "[a] change in the method of accounting includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan. . . . A material item is any item which involves the proper time for the inclusion of the item in income or the taking of a deduction." Treas. Reg. § 1.446- 1(e)(2)(ii)(a) (added emphasis).

³103 T.C. 656 (1994).

⁴Id. at 668.

⁵See Treas. Reg. § 1.446-1(c)(1)(ii)(A) ("Applicable provisions of the Code, the Income Tax Regulations, and other guidance published by the Secretary prescribe the manner in which a liability that has been incurred is taken into account.").

⁶See, e.g., Prop. Treas. Reg. § 1.263(a)- 4(e)(4)(i) (describing special rules applicable to acquisitive transactions); id. § 1.263(a)-4(e)(4)(ii) (describing special rules applicable to divisive transactions); id. § 1.263(a)-4(e)(4)(iii) (describing special rules applicable to defenses against hostile acquisitions); id. § 1.263(a)- 4(e)(6) (describing rules applicable to stock issuance costs of open- ended regulated investment companies); id. § 1.263(a)- 4(e)(3)(i) (describing simplified conventions for compensation, overhead, and de minimis costs).

⁷See Rev. Proc. 2002-9, 2002-3 I.R.B. 1, § 2.01(2) ("In determining whether a taxpayer's accounting practice for an item involves timing, generally the relevant question is whether the practice permanently changes the amount of the taxpayer's lifetime income. If the practice does not permanently affect the taxpayer's lifetime income, but does or could change the taxable year in which income is reported, it involves timing and is therefore a method of accounting.") (citing Rev. Proc. 9131, 1991-1 C.B. 566).

⁸Cf. Convergent Technologies, Inc. v. Commissioner, 70 T.C.M. (CCH) 87 (1995) (noting that the Service's proposed permanent capitalization for costs would not allow for "any deduction whether in one year or over a period of years" and thus did not present an issue of timing).

⁹See Rev. Proc. 2002-9, 2002-3 I.R.B. 1, § 2.01(2) ("The treatment of a material item in the same way in determining the gross income or deductions in two or more consecutively filed tax returns (without regard to any change in status of the method as permissible or impermissible) represents consistent treatment of that item for purposes of § 1.446-1(e)(2)(ii)(a).").

¹⁰See Rev. Proc. 97-27, 1997-1 C.B. 680 ("Unless specifically authorized by the Commissioner, a taxpayer may not request, or otherwise make, a retroactive change in method of accounting regardless of whether the change is from a permissible or impermissible method.") (citing Rev. Rul. 90-38, 19901 C. B. 57).

¹¹Cf. Tate & Lyle, Inc. v. Commissioner, 103 T.C. 656, 668 (1994) ("The total exclusion of an item from the recipient's gross income is a question of characterization that is unrelated to the taxpayer's method of accounting.").

¹²See, e.g., Prop. Treas. Reg. § 1.263(a)- 4(e)(4)(ii)(A) ("An amount paid to facilitate a distribution of stock to the shareholders of a taxpayer is not required to be capitalized under this section if the divestiture is required by law, regulatory mandate, or court order. . . .") (emphasis added).

¹³Cf. Convergent Technologies, Inc. v. Commissioner, 70 T.C.M. (CCH) 87 (1995) (noting that each issuance of warrants by the taxpayer in connection with sales of its products would not constitute separate items subject to different methods of accounting).

¹⁴See Federated Department Stores, Inc. v. Commissioner, 51 T.C. 500 (1968) ("Unless the transactions are basically the same, the accounting treatment would not be a 'change' of accounting but only a 'new' accounting method for a different transaction."), nonacq. 1971-2 C.B. 4, aff'd, 426 F.2d 417 (6th Cir. 1970); cf. Underhill v. Commissioner, 45 T.C. 499, 496 n. 11 (1966) (noting that, although the Service challenged the taxpayer's ability to change a method of accounting for income from speculative obligations acquired in the past, the Service did not question the use of a different method for future acquisitions and implying thereby the Service's willingness to accept different accounting methods on a transaction-by-transaction basis).

¹⁵See Prop. Treas. Reg. § 1.263(a)-4(o)(2).

¹⁶See Treas. Reg. § 1.446-1(e)(3)(i) ("Permission to change a taxpayer's method of accounting will not be granted unless the taxpayer agrees to the Commissioner's prescribed terms and conditions for effecting the change, including the taxable year or years in which any adjustment necessary to prevent amounts from being duplicated or omitted is to be taken into account.").

¹⁷See National Bank of Fort Benning v. United States, 44 A.F.T.R.2d (RIA) 6061, 6066 (M.D. Ga. 1979) (noting that "[s]ection 481 is an express provision otherwise providing and limiting the discretion of" the Commissioner with respect to section 446).

¹⁸See id. at 6065 (holding that the exercise of discretion in imposing terms and conditions requires "a sound exercise of judgment with regard to what is equitable under the facts and the law, directed toward achieving a just result").

¹⁹See, e.g., Prop. Treas. Reg. § 1.263(a)- 4(e)(3)(ii)(C) (de minimis average cost pooling method).