Short Summary:
In October 1977, representatives of Unilever United States, Inc. (Unilever) expressed an interest in acquiring National Starch and Chemical Corporation (National Starch), later named INDOPCO, Inc., through a friendly takeover. In November 1977, National Starch’s directors were formally advised of Unilever’s interest. At that time, National Starch’s counsel, Debevoise, Plimpton, Lyons & Gates (Debevoise), informed its directors that under Delaware law, they had a fiduciary duty to ensure that the takeover was fair to National Starch’s shareholders.
As a result, National Starch engaged Morgan Stanley & Co., Inc. to evaluate its shares, to render a fairness opinion, and to assist National Starch in the event of an attempted hostile takeover. In total, Morgan Stanley charged National Starch $2,225,586: $2,200,000 for investment adviser fees, $7,586 for out-of-pocket expenses, and $18,000 for legal fees. Debevoise also charged National Starch a total of $505,069: $490,000 for legal fees and $15,069 for out-of-pocket expenses.
On its federal income tax return for taxable year 1978, which ended early on August 15, 1978 upon consummation of the friendly takeover, National Starch deducted the $2,225,586 paid to Morgan Stanley, but it did not deduct the $505,069 paid to Debevoise, or other expenses it incurred related to the transaction. The Commissioner of Internal Revenue (Commissioner) cited a deficiency worth the total value of payments made by National Starch to Morgan Stanley. National Starch, now INDOPCO, sought redetermination in the United States Tax Court, asserting the right to deduct the investment banking fees and expenses (Morgan Stanley), and the legal and miscellaneous expenses incurred.
The Tax Court ruled that the expenditures were capital in nature and therefore not deductible under IRC § 162(a) as “ordinary and necessary expenses.” The primary rationale of the Tax Court centered on the long-term benefits afforded to National Starch as a result of the friendly takeover by Unilever. The United States Court of Appeals for the Third Circuit affirmed the Tax Court’s findings that the takeover would benefit National Starch, likely resulting in synergy between the two entities. The Third Circuit rejected National Starch’s argument that because the expenses did not “create or enhance…a separate and distinct additional asset,” they could not be capitalized, and thus they were deductible under IRC § 162(a).
Key Issue:
Whether certain professional expenses (i.e., investment adviser fees, legal fees, etc.) incurred by a target corporation in the course of a friendly takeover are deductible by that corporation as “ordinary and necessary” business expenses under IRC § 162(a)?
Primary Holding:
The expenses incurred by National Starch, including the investment adviser fees, legal fees, etc., are not “ordinary and necessary” expenses to be deducted under IRC § 162. The fact that there is no separate and distinct asset created or enhanced by the expenses is not decisive. Rather, the expenses “bear the indicia” of capital expenditures under IRC § 263.
Key Points of Law:
- “An income tax deduction is a matter of legislative grace” and the taxpayer bears the burden of clearly showing the right to a claimed deduction. See Interstate Transit Lines v. Commissioner, 319 U.S. 590, 593 (1943); Deputy v. Du Pont, 308 U.S. 488, 493 (1940); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).
- IRC § 162(a) allows for the deduction of “all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”
- Contrarily, IRC § 263 does not allow for the deduction of a capital expenditure – an “amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate. IRC § 263(a)(1).
- Deductions are specifically enumerated within the IRC, and subject to disallowance in favor of capitalism. See IRC §§ 161, 261.
- In comparison, capital expenditures are not exhaustively enumerated within the IRC; IRC § 263 serves as a guide to distinguishing capital expenditures from expenses.
- It is for these reasons that the Court concluded that income tax deductions are strictly construed and allowed only “as there is a clear provision therefor.” New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934); Deputy v. Du Pont, 308 U.S. 488, 493 (1940).
- To that end, the Court recognized that distinguishing between capital expenditures and expenses is often a matter of “degree and not of kind,” Welch v. Helvering, 290 U.S. 111, 114 (1933), as the outcome of each case is largely dependent on its specific facts, oftentimes making the cases difficult to harmonize. Deputy v. Du Pont, 308 U.S. 488, 496 (1940); Welch v. Helvering, 290 U.S. 111, 116 (1933).
- In Commissioner v. Lincoln Sav. & Loan Ass’n, the Court ruled that a taxpayer’s expenditure that “serves to create or enhance … a separate and distinct” asset should be capitalized under IRC § 263. 403 U.S. 345 (1971).
- However, in the present case, the Court clarified that the Lincoln Savings ruling did not establish a bright line as the facts that led to the Court’s conclusion were specific to the relevant circumstances.
- In making the distinction between capital expenditure and expense, the Court, and the text of IRC § 263, emphasized the importance of considering the duration and extent of the benefits realized – namely, whether a taxpayer realized benefits beyond the year in which the expenditure was incurred. See United States v. Mississippi Chem. Corp., 405 U.S. 298 (1972); Texas Sav. & Loan Ass’n v. United States, 731 F.2d 1181 (5th Cir. 1984).
- In assessing the proper classification of expenses such as the investment adviser fees, legal fees, and other professional fees at issue in the present case, courts have recognized that expenses “incurred for the purpose of changing the corporate structure for the benefit of future operations are not ordinary and necessary business expenses.” Bancshares Corp. v. Commissioner, 326 F.2d 712, 715 (8th Cir. 1964).
- To the contrary, courts have often characterized expenditures as “capital” because “the purpose for which the expenditure is made has to do with the corporation’s operations and betterment, sometimes with a continuing capital asset, for the duration of tis existence or for the indefinite future or for a time somewhat longer than the current taxable year.” Bancshares Corp. v. Commissioner, 326 F.2d 712, 715 (8th Cir. 1964).
Insight:
The INDOPCO decision was criticized as creating an unworkable standard. Following the Court’s ruling, expenses incurred that improved or created a separate and distinct asset (See Lincoln Savings) and those that created significant, as opposed to incidental, future benefits had to be capitalized under IRC § 263(a).
In 2004, more than a decade after the INDOPCO decision, Treasury issued final regulations, subject to change or repeal, governing the capitalization of intangible asset-related expenses: Treas. Reg. § 1.263(a)-4, Amounts Paid to Acquire or Create Intangibles; Treas. Reg. § 1.263(a)-5, Amounts Paid or Incurred to Facilitate an Acquisition of a Trade or Business, a Change in the Capital Structures of a Business Entity, and Certain Other Transactions.
Per Treas. Reg. § 1.263(a)-4(b), a taxpayer must capitalize (i) an amount paid to acquire an intangible from a third party; (ii) an amount paid to create an intangible; (iii) an amount paid to create or enhance a separate and distinct intangible asset, or a future benefit identified as an intangible; (iv) an amount paid to facilitate an acquisition or creation of an intangible. A “separate and distinct intangible asset” is defined as a property interest of ascertainable and measurable value in money’s worth that is subject to protection under applicable state, federal, and foreign law and the possession and control of which is intrinsically capable of being sold, transferred or pledged separate and apart from a trade or business. See Treas. Reg. § 1.263(a)-4(b)(3)(i). Whether expenses fall into one of the categories that require capitalization is primarily a facts and circumstances inquiry.
Per Treas. Reg. § 1.263(a)-5(a), a taxpayer must capitalize costs incurred to facilitate any of the listed transactions. An amount is paid to facilitate a transaction within the meaning of the Regulation if the amount is paid in the process of investigating or otherwise pursuing the transaction. Such a determination is made based on an inquiry into the relevant facts and circumstances. Treas. Reg. § 1.263(a)-5(b)(1). Additionally, the Regulations specify amounts paid that are “inherently facilitative,” and thus capitalized, as well as exceptions to the rule and safe harbors. See Treas. Reg. § 1.263(a)-5(e). Regulations also provide for the treatment of capitalized costs in various scenarios. See Treas. Reg. § 1.263(a)-5(g).
