Editor: Mark G. Cook, CPA, CGMA
In Technical Advice Memorandum (TAM) 202121009, the IRS Office of Chief Counsel advised that a taxpayer must capitalize the excess amounts paid to acquire a debt instrument under Sec. 263. The TAM provides an analysis of the capitalization of amounts paid to acquire or create intangibles, providing insight into capital expenditures under Sec. 263 and trade or business expenses under Sec. 162, clarifying capitalizing vs. expensing.
The TAM describes a consolidated manufacturer (Taxpayer) and its captive finance subsidiary (Finance Company), a consolidated group member. As part of its trade or business, Finance Company purchases contracts from an independent party (Brand Retailer) that is not a member of Taxpayer's consolidated group. The purchase of a contract by Finance Company from Brand Retailer is memorialized in an agreement.
The agreement states that the purchase price of a contract is its principal amount, which Taxpayer claims is the contract's fair market value (FMV). The agreement also defines the Finance Company's Retailer Program. Under this program, Finance Company agrees to make Retailer Program payments to Brand Retailer as compensation for purchase of the contract. These payments, made under three different formulas set out in the agreement, are paid separately from the purchase price of the contract. All of the Retailer Program payments are tracked to a specific contract.
In the taxpayer's industry, it is common for product manufacturers like Taxpayer to offer a promotional below-market interest rate to increase sales. Taxpayer offers such a program, under which it authorizes Brand Retailer to make contracts with purchasers for the sale of Brand 1 and Brand 2 products at below-market interest rates. When Finance Company purchases a contract made under the program from Brand Retailer, Finance Company purchases it for the contract principal amount, even though the principal amount of the contract is greater than the fair value of the below-market interest rate contract. Taxpayer reimburses Finance Company for this difference through an interest rate subvention payment, thereby shifting the cost of the below-market interest rate program from Finance Company to Taxpayer. Taxpayer claims that the subvention payment is a sales and marketing expense that is deductible under Sec. 162.
In general, a taxpayer must capitalize any expenditures to acquire (in a purchase or similar transaction) or create intangibles, create or enhance separate and distinct intangibles (or certain future benefits identified in published guidance as an intangible), or to facilitate the acquisition or creation of intangibles (Regs. Sec. 1.263(a)-4(b)(1)). Intangible assets acquired by a purchase or a similar transaction include debt instruments (Regs. Sec. 1.263(a)-4(c)(1)(ii)).
Under Sec. 162(a), a taxpayer may deduct any trade or business expense that is ordinary and necessary and paid or incurred during the current tax year. On the other hand, a taxpayer is prohibited under Sec. 263(a) from deducting any amounts paid to acquire new buildings, to make permanent improvements to enhance a property's value, or to restore and enhance a property.
Under the actual-transaction doctrine, a taxpayer must report the tax consequences of the actual transaction rather than those that could have resulted from alternative forms of the transaction (National Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 148-49 (1974)).
The IRS's and the taxpayer's arguments
The IRS Large Business and International Division (LB&I) requested advice from the Chief Counsel's Office on the proper treatment of the Retailer Program payments. LB&I argued that the Retailer Program payments that Financing Company makes to Brand Retailer are payments made to acquire the contract. Therefore, Taxpayer must capitalize those payments.
Taxpayer argued that the purchase price of a contract is its principal amount (the FMV of the contract) and that a Retailer Program payment is a separate payment in excess of the contract's FMV that is deductible as advertising and promotional costs under Sec. 162. Taxpayer maintained that this was the case because the Retailer Program payment improves the relationships among Finance Company, Brand Retailer, Taxpayer, and purchasers of Taxpayer's products by increasing sales of Taxpayer's products and add-on products and services to purchasers and by increasing the number of contracts sold to Finance Company by Brand Retailer. As further support for its argument that the Retailer Program payments were deductible sales and marketing expenses, Taxpayer claimed that the Retailer Program payments were analogous to Taxpayer's interest subvention payments.
The Chief Counsel's Office advised that Taxpayer must capitalize the Retail Program payments because treating the payments as deductible was not supported by the terms of the contract agreements. It noted that the contract agreements specifically stated that payments made under the Retailer Program are compensation by Finance Company to Brand Retailer for the purchase of contracts and each payment was tracked to a specific contract. Thus, all the Retailer Program payments were amounts paid to acquire contracts.
Taxpayer argued the Retailer Program payments were analogous to Taxpayer's interest subvention payments. In both circumstances, Taxpayer noted, the difference between the principal amount of the contracts and their FMV was attributable to Taxpayer's promotion to sell its products. Therefore, Taxpayer claimed, the Retailer Program payments were deductible sales and marketing expenses like the interest subvention payments. The Chief Counsel's Office rejected this argument, finding that the structure and economics of the Retail Program payments and the subvention payments were not the same.
The Chief Counsel's Office explained that the interest subvention payments were paid to Finance Company under Taxpayer's below-market interest rate promotion, and the promotion ultimately benefited the purchaser of Taxpayer's products. Thus, the subvention payment resembled a sales or marketing expense. In contrast, under the contract agreement, Finance Company's Retailer Program included the Retail Program payments as compensation to Brand Retailer for a below-market, at-market, or above-market contract. This was a direct benefit to Brand Retailer, which was unlikely to know the details of the contract purchase transaction between Finance Company and Brand Retailer, but was of little or no benefit to the purchaser of Taxpayer's products.
Moreover, even if the payments were similar, Taxpayer was precluded by the actual-transaction doctrine from asserting that the two types of payments were equivalent for tax purposes. Under the doctrine, Taxpayer was bound by the results of the form of the transaction it actually undertook and could not claim the tax effects of an alternative form of the transaction that it could have undertaken but chose not to.
Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-623-0478 or email@example.com.
Contributors are members of SingerLewak LLP.