January 1999 Issue

COST CAPITALIZATION DEVELOPMENTS

By Viva Hammer, JD PricewaterhouseCoopers LLP

The Tax Court recently handed two cost capitalization victories to the IRS. In FMR Corp. and Subsidiaries v. Comm'r, 110 T.C. 402 (1998), the court concluded that an investment management company was not entitled to current deductions for costs incurred to develop and launch new mutual funds. Moreover, the court agreed with the IRS that, because no useful life could be shown for the future benefits generated by those costs, the capitalized amounts were not amortizable under section 167. In the case of U.S. Bancorp and Consolidated Subsidiaries v. Comm'r, 110 T.C. No. 10, 9/21/98, the court concluded that lease termination fees paid by a bank to terminate its interest in leased computer equipment, financed over the life of a new lease with the same lessor, were not currently deductible.

The First Victory

Fidelity Management & Research Co. (Fidelity) is an operating subsidiary of FMR Corp. Fidelity renders investment advisory services to the Fidelity family of funds. These services are rendered pursuant to management contracts entered into with each fund. In addition, other divisions or subsidiaries of FMR render distribution, recordkeeping, and cash management services to the funds. During the years at issue, FMR created 82 new funds and entered into separate management contracts with each. The fees charged under the management contracts varied, but all were dependent upon the level of assets under management in each fund. Fees for recordkeeping and cash management services were generally based upon a fund's average net assets.

The costs at issue represented those amounts incurred in launching the funds. The launch period runs from the point of the development of the idea for the new fund through the time at which the fund is registered with the SEC and the appropriate state authorities. Typically, these costs would include attorneys' fees, accounting fees, registration costs, and expenses associated with market research and analysis.

The court directed its inquiry to the duration and extent of any benefits FMR received from its expenditures, rather than to whether a separate and distinct asset had been created. The court found that, in establishing the funds, FMR anticipated being awarded the initial management contract. Indeed, those contracts were not only initially awarded, but generally continued indefinitely. (Fidelity had never been replaced as fund advisor in its history of investment management services.) In addition, the court found that the establishment of the new funds was intended to provide existing investors with incentives to increase their investment in the Fidelity fund family. Increases in investment meant greater revenues to FMR. Finally, the court determined that the right to market a particular fund's investment concept was a valuable intangible.

FMR argued that the launch costs were nothing more that costs incurred to expand its existing business, and were deductible under pre-INDOPCO cases such as Briarcliff Candy Corp. v. Comm'r, 475 F.2d 775 (2d Cir., 1973). The court effectively rejected this reliance as misplaced after the INDOPCO decision, and concluded that the correct inquiry is whether the costs created a significant future benefit, not whether those costs are properly classified as expansion costs.

Finally, the court determined that the costs could not be amortized for lack of a demonstrable life. Although FMR calculated a useful life based on an analysis of the estimated duration of initial investment in the fund, the court found no basis for limiting the analysis to initial investments.

The court found that the benefits were significant and long lasting, and concluded that FMR failed to produce any information that would permit the establishment of a definitive life. Accordingly, amortization was not permitted. The court's focus on the stream of management fee income to be received over an indeterminate period may open additional avenues of challenge to the IRS in the context of the banking business. The essence of banking is the acquisition of cash flows in excess of cash outflows. In some cases, those cash flows are associated with particular assets (such as loans). In other cases, those cash flows are associated with services to be performed (such as servicing fee income). In any event, it seems as though this victory may invite the IRS to reconsider its attack on cost capitalization in the banking context.

The Second Victory

U.S. Bancorp leased a mainframe computer under a master lease agreement with IBM Credit Corp. (IBM). During the initial year of the lease, the bank determined that a more powerful computer was required. Although the master lease agreement contained no provision for early termination of the lease, IBM and the bank executed a rollover agreement under which IBM agreed to terminate the existing lease, provided the replacement computer was financed through IBM. Under the agreement, the bank was required to pay a termination fee on the first lease that was financed over the term of the new lease. Based on a review of other documents, the court determined that the termination charge would have been greater if the new computer had not been leased from IBM.

Finding that the first and second leases were integrally related to one another, the court distinguished the facts from the case in which a lessee pays a termination fee to exit a lease. In this latter instance, the termination fee is solely attributable to the terminated lease. In U.S. Bancorp's case, however, the termination fee could also be viewed as part of the cost of entering into the new lease. The court found that the termination agreement obligated the bank, legally and economically, to enter into the second lease with IBM. The new lease provided the bank with a more useful computer than it had been entitled to use under the old lease, resulting in the realization of future benefits over the term of the new lease. Accordingly, the termination fee was capitalized and amortized over the life of the second lease.

Although the court's thinking in this case is not necessarily new, the rationale for its conclusion is startlingly similar to the rationale used by the IRS to require the capitalization of exit and entrance fees charged to institutions moving from the SAIF to the BIF. The decision may breathe new life into the IRS's challenge on this issue. *

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