TAXATION OF FINANCIAL PRODUCTS

TAX COURT DECIDES BANK'S LOAN ORIGINATION EXPENDITURES ARE CAPITAL

By Viva Hammer, Esq. PricewaterhouseCoopers LLP

In the recent ruling of PNC Bancorp, Inc. v. Comm'r (T.C. No. 16002-95, 110 T.C. No. 27, 6/8/98), the U.S. Tax Court has held that loan origination expenditures incurred by a bank are not currently deductible as business expenses but are capital expenditures that must be recovered through amortization. The court reasoned that the loan origination expenditures were incurred in the creation of the loans, and are therefore separate and distinct assets generating income over a period of years. As such, they must be capitalized and amortized over the life of the loans. The court also observed that capitalization and amortization resulted in a better matching of the expenses with the income stream to be generated by the separate assets.

Costs that potentially may be required to be capitalized and amortized in accordance with the court's ruling include amounts paid to record security interests and to engage third parties to prepare property reports, credit reports, and appraisals, as well as an allocable portion of the salaries and fringe benefits paid to employees for evaluating the borrower's financial condition; evaluating guaranties, collateral, and other security arrangements; negotiating loan terms; preparing and processing loan documents; and closing loan transactions. The current widespread financial industry tax treatment of these types of expenditures is to deduct them in the year in which they are incurred.

The Issue

The sole issue before the Tax Court was whether the expenditures described in SFAS 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases, incurred in connection with the origination of loans are deductible as ordinary and necessary business expenses under IRC section 162 or whether, as argued by the IRS, they are not deductible because IRC section 263 requires that they be capitalized.

The IRS argued that the loans constituted separate and distinct assets of the banks. Therefore, under the rule in Comm'r v. Lincoln Savings and Loan, the expenses incurred to create or enhance separate and distinct assets are by their very nature capital.

The taxpayer argued that "other factors" were present that allowed deductibility of the loan origination costs--specifically, that the type of costs at issue 1) were incurred on a daily basis in the banking industry, 2) were an integral part of the day-to-day operation of the bank, and
3) provided only short-term benefits.

Discussion and Conclusions

Everyday, Recurring Expenses. The taxpayer cited several cases allowing deductions for credit evaluation and recordkeeping costs similar to the costs at issue, noting that such costs are "everyday, recurring" costs of operating a bank. The court found these cases distinguishable from the present case, however, since they did not involve the creation or enhancement of separate and distinct assets or property interests but were instead related to the active conduct of an existing business.

Expenses Integrally Related to the Business. The court also rejected the taxpayer's argument that the expenses should be deductible because they are "integrally related to the conduct of the bank's business" and that, under an overly expansive view of IRC section 263, all costs theoretically could be allocated in some manner to the acquisition or enhancement of assets (which would cause the elimination of IRC section 162 deductions altogether). The court stated that concern regarding an overly expansive application of IRC section 263 was unwarranted in the present case since the expenses at issue were directly related to the creation of the loans. (Generally, only direct costs are required to be capitalized under SFAS 91.)

Short-term Benefit of Expenses. The taxpayer also asserted that because credit reports, appraisals, and similar financial data produce short-lived benefits, expenses related thereto should be deductible. The court disagreed, stating that although such financial information may become outdated in a short period of time, the "quality of the decision to make a loan (and thereby acquire an asset) is predicated on such information [and] [t]he soundness of the decision-making process should be assimilated into the asset that was acquired." Therefore, the direct costs of the decision-making process should be factored into the cost of the asset created or acquired, the court concluded.

Other Issues Addressed by Court

Finally, the court rejected the taxpayer's arguments relating to application of the change in method of accounting rules and the doctrine of legislative necessity. The taxpayer contended that, because the banks had consistently deducted the costs at issue in accordance with industry practice, capitalization would constitute a change in method contrary to IRC section 446(a) (which permits taxpayers to compute taxable income under the method of accounting which taxpayers regularly use to compute income when keeping their books). The court, citing authority that consistency is "not a substitute for correctness," concluded that the bank's current deduction of expenses did not clearly reflect income and therefore was not a proper method.

The taxpayer also failed to convince the court that because Congress had enacted specific legislation regarding the income taxation of banks but had not availed itself of the opportunity to address the deductibility of loan origination costs, Congress should be understood to favor the widespread current industry practice of deducting such expenses. The court reiterated the general rule that deductions are a matter of legislative grace that are strictly construed and concluded that Congress' inaction in this area had no relevance to the current case.

Observation

A number of taxpayers are awaiting action on protests of proposed loan origination cost adjustments and on accounting method requests for loan origination costs. The IRS national office had indicated it was deferring providing guidance, pending the outcome of this case. Although it is uncertain whether the taxpayer intends to appeal the decision, the case may motivate the IRS to provide published guidance on this issue. *

Editor:
Viva Hammer, Esq.
PricewaterhouseCoopers LLP

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