PNC Bancorp Inc. v. IRS Commissioner , 212 F.3d 822 ( 2000 )

Opinions of the United
2000 Decisions States Court of Appeals
for the Third Circuit
5-19-2000
PNC Bancorp Inc. v. IRS Commissioner
Precedential or Non-Precedential:
Docket 99-6020
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Filed May 19, 2000
UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT
No. 99-6020
PNC BANCORP, INC.,
Successor to First National Pennsylvania Corporation
v.
COMMISSIONER OF INTERNAL REVENUE
(Tax Court No. 95-16002)
PNC BANCORP, INC.,
Transferee of Assets of First National Pennsylvania
Corporation
v.
COMMISSIONER OF INTERNAL REVENUE
(Tax Court No. 95-16003)
PNC BANCORP, INC.,
Successor to United Federal Bancorp, Inc., and
Subsidiaries
v.
COMMISSIONER OF INTERNAL REVENUE
(Tax Court No. 96-16109)
PNC BANCORP, INC.,
Transferee of Assets of United Federal Bancorp, Inc., and
Subsidiaries
v.
COMMISSIONER OF INTERNAL REVENUE
(Tax Court No. 96-16110)
PNC Bancorp, Inc., as (i) Successor to First National
Pennsylvania Corporation, (ii) Transferee of Assets of First
National Pennsylvania Corporation, (iii) Successor to
United Federal Bancorp, Inc., and Subsidiaries, and (iv)
Transferee of Assets of United Federal Bancorp, Inc.,
and Subsidiaries,
Appellant
On Appeal from the Commissioner of Internal Revenue,
Decision of the United States Tax Court
(Tax Court Nos. 95-16002, 95-16003, 96-16109,
and 96-16110)
Tax Court Judge: Honorable Robert P. Ruwe
Argued October 21, 1999
Before: SLOVITER, RENDELL, Circuit Judges,
and BYRNE, District Judge*
(Filed: May 19, 2000)
Robert J. Jones, Esq. (ARGUED)
Roger P. Colinvaux, Esq.
Arnold & Porter
555 12th Street, N.W.
Washington, DC 20004
Attorneys for Appellant
Richard Farber, Esq.
Annette M. Wietecha, Esq.
(ARGUED)
U.S. Department of Justice
Tax Division
P.O. Box 502
Washington, DC 20044
Attorneys for Appellee
_________________________________________________________________
* The Honorable Wm. Matthew Byrne, Jr., United States Senior District
Judge for the Central District of California, sitting by designation.
2
Michael F. Crotty, Esq.
American Bankers Association
1120 Connecticut Avenue, N.W.
Washington, DC 20036
Attorney for Amicus-Appellant
American Bankers Association
Maureen E. Mahoney, Esq.
Latham & Watkins
1001 Pennsylvania Avenue, N.W.
Suite 1300
Washington, DC 20004
Attorney for Amicus-Appellant
National Association of
Manufacturers
Ronald W. Blasi, Esq.
Georgia State University
College of Law
P.O. Box 4037
Atlanta, GA 30302
Attorney for Amicus-Appellant
Ronald W. Blasi
OPINION OF THE COURT
RENDELL, Circuit Judge.
In this appeal from a decision of the Tax Court, we are
asked to determine whether certain costs incurred by
banks for marketing, researching and originating loans are
deductible as "ordinary and necessary expenses" as
provided by section 162 of the Internal Revenue Code, 26
U.S.C. S 162 (1988), or whether these expenses must be
capitalized under section 263 of the Code. Two banks that
were predecessors in interest of appellant PNC Bancorp,
Inc. deducted these costs as ordinary business expenses.
The Internal Revenue Service disallowed the deductions and
issued statutory notices of deficiency. PNC filed petitions for
redetermination with the Tax Court. The Tax Court
determined that the expenses in question were not
deductible, but, instead, must be capitalized and amortized
3
over the life of the subject loans. PNC now appeals from
this determination.
We hold that the costs at issue were deductible as
"ordinary and necessary" expenses of the banking business
within the meaning of Internal Revenue Code section 162,
and that these costs do not fall within the purview of
section 263. Accordingly, we will reverse the judgment of
the Tax Court.
I. Genesis of the Dispute
The costs that the banks seek to deduct are the internal
and external costs that they incur in connection with the
issuance of loans to their customers. These costs,
discussed in more detail below, are a routine part of the
banks' daily business, and the services procured with these
outlays have been integral to the basic execution of the
banking business for decades.
The general contours of banks' involvement in making
loans have not changed dramatically in recent years, and
the relevant sections of the Tax Code have remained largely
unchanged. Historically, the costs at issue have been
deductible in the year that they are incurred; however, the
Commissioner rejected this tax treatment by PNC. Why is
the Commissioner now insisting upon capitalization of
these costs?
There are two relatively recent developments that appear
to have emboldened the Internal Revenue Service to pursue
capitalization of such costs. One of these developments is
the Supreme Court's opinion in INDOPCO, Inc. v.
Commissioner, 503 U.S. 79 (1992), in which the Court held
that expenses incurred by a target corporation in the
course of its friendly acquisition by another entity were not
currently deductible. See id. at 90. INDOPCO, which
signaled that the Supreme Court's previously announced
tests for capitalization were not exhaustive, may well have
been viewed by the IRS as a green light to seek
capitalization of costs that had previously been considered
deductible in a number of businesses and industries. This
phenomenon has not escaped comment from observers.
See, e.g., W. Curtis Elliott Jr., Capitalization of Operating
4
Expenses After INDOPCO: IRS Strikes Again, S.C. Law.,
Sept./Oct. 1993, at 29, 29, 30 (commenting on the IRS's
"recently aggressive posture on capitalization" after
INDOPCO, and noting that while the INDOPCO decision
itself was not "necessarily troubling," the IRS's
interpretation of it has stretched far beyond the scenario
presented in INDOPCO); IRS Loses Battle in INDOPCO War:
Advertising Remains Deductible, Taxes on Parade, July 16,
1998, at 1 (describing the "IRS's INDOPCO-fueled
juggernaut"). Thus, INDOPCO ushered in an era of generally
more aggressive IRS pursuit of capitalization.
An additional development may have prompted the IRS's
assertive posture in the more specific case of the loan
origination costs at issue here. This second development
was the Financial Accounting Standards Board's
promulgation of a new standard for financial accounting
treatment of loan origination costs, Statement of Financial
Accounting Standards No. 91 ("SFAS 91").1 Beginning in the
late 1980s, SFAS 91 required for the first time that, for
financial accounting purposes, loan fee income and the
costs incurred in connection with loan origination should
be deferred and recognized over the life of the loan, rather
than being recognized in full in the year the loan closed.2
The FASB's authority extends only to financial accounting
standards and not to tax accounting standards. For the
first few years of SFAS 91's existence, the IRS did not
require capitalization of the loan origination costs described
in this financial accounting standard. However, the IRS
apparently viewed INDOPCO as a reason to pursue
capitalization of the costs that SFAS 91 requires to be
deferred.3 Thus, the stage for this litigation was set.
_________________________________________________________________
1. The Financial Accounting Standards Board ("FASB") is an independent
private sector organization that establishes standards for financial
accounting and reporting. The Securities and Exchange Commission
recognizes the FASB's financial accounting standards as authoritative.
See UAW Local No. 1697 v. Skinner Engine Co., 188 F.3d 130, 136 n.4
(3d Cir. 1999).
2. SFAS 91 became effective for accounting years that began after
December 15, 1987.
3. Although the Commissioner and the Tax Court both claimed that they
were not relying on the financial accounting standards of SFAS 91 in
5
II. Factual Background
PNC Bancorp, Inc. (PNC) is a bank holding company
incorporated in Delaware. See A. at 102. Two smaller
banking entities, First National Pennsylvania Corporation
(FNPC) and United Federal Bancorp, Inc. (UFB), were
merged into PNC in 1992 and 1994, respectively, and PNC
succeeded to the liabilities of both these companies. See A.
at 103, 105. The activities at issue in this case occurred
before the mergers and were performed by FNPC and UFB
or their subsidiaries.4
The costs challenged in this appeal were incurred by both
banks in connection with the origination of loans. 5 There
are two categories of such "loan origination costs," as they
have been called.6 The first category includes payments
made to third parties for activities that help the bank
determine whether to approve a loan (credit screening,
property reports, and appraisals) and for the recording of
security interests when the bank decides to issue a secured
_________________________________________________________________
determining the tax treatment of the costs at issue, the IRS appears to
have imported the result of these financial accounting standards into the
tax arena without engaging in independent analysis of why these costs
should be subject to different tax treatment than the majority of
everyday business costs, and without considering the secondary tax
ramifications that would flow from a requirement of capitalization. See
infra note 16; see also Tr. of Oral Argument at 27 (conceding that SFAS
91 effectively determined where the IRS would "draw the line" between
deductibility and capitalization in this case).
4. For FNPC, the tax years at issue are 1988 and 1990; for UFB, the
years at issue are 1990, 1991, 1992 and 1993.
5. The IRS contested FNPC's claimed deductions for origination of both
consumer and commercial loans, but contested UFB's deductions only
for costs incurred in originating consumer loans. See A. at 137. The Tax
Court opinion noted that it was unclear why the IRS pursued
commercial loan activities only in the case of one of the two banks. See
PNC Bancorp, Inc. v. Commissioner, 110 T.C. 349, 355 n.9 (1998).
6. The parties disagree as to the appropriate name for this collection of
costs -- the Commissioner prefers "loan origination expenses," while PNC
prefers "risk management and marketing costs." However, as there is no
dispute about which costs are included in this group, the disagreement
is largely semantic. In this opinion, we will use the terms "loan
origination costs" or "loan marketing costs" to denote the costs at issue.
6
loan. The second category consists of internal costs, namely
that portion of employee salaries and benefits that can be
attributed to time spent completing and reviewing loan
applications, and to other efforts connected with loan
marketing and origination.7 The Commissioner pursued
capitalization of loan origination costs only when those
costs were incurred in connection with a loan that was later
approved; the Commissioner allowed the banks to deduct
origination costs expended in connection with loans that
were not successfully approved. See PNC Bancorp, Inc. v.
Commissioner, 110 T.C. 349, 359, 362 (1998); see also Tr.
of Oral Argument at 7.
Loan interest constituted the largest source of revenue
for each bank during the relevant time period, and interest
on deposits and other borrowing constituted the largest
expense. See A. at 108.8 It is undisputed that banks
generally can be profitable only if they successfully manage
their "net interest margin" -- the difference between
interest earned and interest paid. A profitable bank's net
interest margin plus its revenues from fees and other
sources must exceed its losses on loans and investments.
See A. at 108.
Bank personnel routinely undertook loan marketing
activities in tandem with other marketing and customer
service functions. Both tellers and "platform employees"
(those bank employees who have desks apart from the teller
windows) were encouraged to "cross-sell," that is, to sell
multiple products to existing and new customers who came
to the bank in search of a particular product or service. For
example, if a new customer opened a checking and savings
account, the bank representative might also suggest a
certificate of deposit or a loan. Likewise, when a consumer
applied for a loan, the employee taking the application was
_________________________________________________________________
7. The parties have stipulated to most of the facts concerning the loan
origination activities and the role that loan origination plays in the
banking business.
8. As the Tax Court put it, the banks' "principal businesses . . .
consisted of accepting demand and time deposits and using the amounts
deposited, together with other funds, to make loans." PNC, 110 T.C. at
351.
7
also expected to sell other bank products and services
(such as checking accounts, credit lines, or ATM cards)
during that same session. The banks provided financial
incentives to their tellers and platform employees for each
successful "cross-sale," see A. at 110, and such "cross-
sales" were a routine part of each bank's daily business.9
Before 1988, FNPC and UFB treated their loan
origination costs in the same manner as their other routine
expenses, both for tax accounting and financial accounting
purposes. That is, they reported these costs for the tax year
(and the fiscal year) in which the costs were incurred. This
practice was apparently standard in the banking industry
at that time. See A. at 169. In 1988, following the
promulgation of SFAS 91, FNPC and UFB began to separate
out their loan origination costs for financial accounting and
reporting purposes in order to conform with SFAS 91's
requirements. However, both banks continued to deduct
loan origination costs for tax purposes in the tax year in
which the loan closed. See A. at 124, 134. It is these
deductions that the Commissioner and the Tax Court
disallowed.
III. Jurisdiction and Standard of Review
The Tax Court had jurisdiction over PNC's petitions for
redetermination pursuant to 26 U.S.C. SS 6213 and 7442.
We have appellate jurisdiction pursuant to 26 U.S.C.
S 7482(a)(1), which states that "[t]he United States Courts of
Appeals . . . shall have exclusive jurisdiction to review the
decisions of the Tax Court . . . in the same manner and to
the same extent as decisions of the district courts in civil
actions tried without a jury." Thus, we have plenary review
over the Tax Court's findings of law, including its
construction and application of the Internal Revenue Code.
See National Starch & Chem. Corp. v. Commissioner, 918
F.2d 426, 428 (3d Cir. 1990), aff 'd, INDOPCO, Inc. v.
Commissioner, 503 U.S. 79 (1992). We review the Tax
Court's factual findings and inferences for clear error. See
_________________________________________________________________
9. At UFB, the average number of products and services sold to a new
customer at a loan session was six, including the loan. See A. at 53.
8
id.; see also Pleasant Summit Land Corp. v. Commissioner,
863 F.2d 263, 268 (3d Cir. 1988).
IV. Discussion
There is a fundamental distinction between business
expenses and capital outlays. The primary consequence of
characterizing a payment as a business expense or a
capital outlay "concerns the timing of the taxpayer's cost
recovery," INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 83
(1992): business expenses are deductible in the year in
which they are incurred, whereas a capital outlay is
generally "amortized and depreciated over the life of the
relevant asset, or, where no specific asset or useful life can
be ascertained, is deducted upon dissolution of the
enterprise," id. at 83-84.
Two sections of the Internal Revenue Code address the
deductibility vel non of expenditures such as those incurred
by FNPC and UFB. Section 162 of the Internal Revenue
Code provides in pertinent part: "There shall be allowed as
a deduction all the ordinary and necessary expenses paid
or incurred during the taxable year in carrying on any trade
or business . . ." 26 U.S.C. S 162(a). Section 263 of the
Code states that capital expenditures, i.e.,"amount[s] paid
out for new buildings or for permanent improvements or
betterments made to increase the value of any property or
estate," cannot be currently deducted. 26 U.S.C.S 263(a)(1).
It is true that these two sections are neither all-inclusive
nor mutually exclusive. See General Bancshares Corp. v.
Commissioner, 326 F.2d 712, 716 (8th Cir. 1964) (written
by then-Judge Blackmun). For example, it is possible that
an expense that might appear to be deductible under
section 162(a) might instead be required to be capitalized
because it also properly falls under the description provided
by section 263(a). If an expense were to fall under the
language of section 263(a), that section would "trump" the
deductibility provision of section 162(a) and the expense
would have to be capitalized. Thus, in order to be
deductible, the expense must both be "ordinary and
necessary" within the meaning of section 162(a) and fall
outside the group of capital expenditures envisioned by
9
section 263(a).10 Nonetheless, the two sections represent the
archetypes of the two opposing alternatives for tax
treatment of expenditures -- deduction and capitalization
-- and, ordinarily, an expenditure will fall under one or the
other section, not both.
The taxpayer bears the burden of showing that a given
expenditure is deductible. See Interstate Transit Lines v.
Commissioner, 319 U.S. 590, 593 (1943), quoted in
INDOPCO, 503 U.S. at 84. In order to demonstrate
deductibility under section 162(a) of the Code, the taxpayer
must meet a five-part test. "To qualify as an allowable
deduction under S 162(a) . . . , an item must (1) be `paid or
incurred during the taxable year,' (2) be for `carrying on any
trade or business,' (3) be an `expense,' (4) be a`necessary'
expense, and (5) be an `ordinary' expense." Commissioner v.
Lincoln Sav. & Loan Ass'n, 403 U.S. 345, 352 (1971). It is
clear that PNC's loan origination expenses can satisfy the
first four parts of this test.11 The question before us under
S 162, then, is whether these expenses qualify as "ordinary"
business expenses within the meaning of that section.
In determining what expenditures qualify as "ordinary,"
we must look to the particular facts of the case before us,
including the particular puzzle posed by the circumstances
of the banking industry. As Justice Cardozo stated nearly
seventy years ago in interpreting an earlier version of this
long-standing Code provision, ordinariness is "a variable
affected by time and place and circumstance." Welch v.
Helvering, 290 U.S. 111, 113-14 (1933). In interpreting the
_________________________________________________________________
10. Section 161 of the Code provides the appropriate method for reading
the two provisions in sequence: "In computing taxable income [ ], there
shall be allowed as deductions the items specified in this part, subject
to the exceptions provided in part IX (sec. 261 and following, relating to
items not deductible)." 26 U.S.C. S 161. Therefore, an expense that is
judged ordinary and necessary under section 162 can be deducted only
if it also does not trigger any of the capitalization provisions beginning
in section 261.
11. The requisite showing that an expense is"necessary" is a minimally
burdensome one; to meet it, a taxpayer need show only that the
expenditures were "appropriate and helpful." Welch v. Helvering, 290
U.S. 111, 113 (1933) (citing McCulloch v. Maryland, 17 U.S. (4 Wheat.)
316 (1819)).
10
Code, we should not stray from the moorings of the
"natural and common meaning" of the term "ordinary," id.
at 114, and in doing so must examine the nature of the
day-to-day operations of the particular business being
considered. See also Deputy v. du Pont, 308 U.S. 488, 495-
96 (1940) (stating that each case "turns on its special
facts," and that an expense that is ordinary-- "normal,
usual, or customary" -- in one business may not be
ordinary in another). Justice Cardozo's oft-quoted words
regarding the heavily case-specific nature of this inquiry are
no less appropriate today than they were in 1933:
Here, indeed, as so often in other branches of the law,
the decisive distinctions are those of degree and not of
kind. One struggles in vain for any verbal formula that
will supply a ready touchstone. The standard set up by
the statute is not a rule of law; it is rather a way of life.
Life in all its fullness must supply the answer to the
riddle.
Welch, 290 U.S. at 114-15; see also Commissioner v. Lincoln
Sav. & Loan Ass'n, 403 U.S. 345, 353 (1971). Accordingly,
we pursue a real-life inquiry into whether the expenditures
associated with loan marketing and origination are
"ordinary" expenses incurred in the day-to-day
maintenance of a bank's business.
The Commissioner has conceded that loan interest was
the banks' largest revenue source during the period in
question, and that interest payments on deposits and other
borrowing were their largest expense. There is no reason to
suppose that this time period was any different from any
other in this regard. Further, maximizing the "net interest
margin" -- the difference between interest received and
interest paid out -- is the principal manner in which banks
earn their keep. As the Tax Court stated, "[t]he principal
businesses of [the banks] consisted of accepting demand
and time deposits and using the amounts deposited,
together with other funds, to make loans." PNC, 110 T.C. at
351. Modern banks are essentially dealers in money. See
United States v. Philadelphia Nat'l Bank, 374 U.S. 321, 326,
327 n.5 (1963).
Given this context, the ordinary nature of the costs at
issue, routinely incurred in the banks' businesses, would
11
seem clear. In order to ensure deductibility, however, we
must also ascertain whether these costs were expended for
betterments to increase the value of property in a way that
would require these costs' capitalization underS 263. We
cannot conclude that in performing credit checks,
appraisals, and other tasks intended to assess the
profitability of a loan, the banks "stepped out of [their]
normal method of doing business" so as to render the
expenditures at issue capital in nature. Encyclopaedia
Britannica, Inc. v. Commissioner, 685 F.2d 212, 217 (7th
Cir. 1982). As we stated in National Starch, an important
determination is whether given expenditures "relate to the
corporation's operations and betterment into the indefinite
future," indicating the need for capitalization, or are instead
geared toward "income production or other current needs,"
suggesting deductibility. National Starch & Chem. Corp. v.
Commissioner, 918 F.2d 426, 433 (3d Cir. 1990), aff 'd,
INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992). The
facts before us demonstrate that loan operations are the
primary method of income production for the subject
banks. We have no doubt that the expenses incurred in
loan origination were normal and routine "in the particular
business" of banking. See Deputy v. du Pont , 308 U.S. at
496.
The Commissioner argues, and the Tax Court found, that
the Supreme Court's decision in Lincoln Savings requires a
different result. We disagree. In Lincoln Savings, the
Supreme Court concluded that payments made by Lincoln
Savings and Loan Association into a "Secondary Reserve"
fund at the Federal Savings and Loan Insurance
Corporation (FSLIC) were not deductible as ordinary
business expenditures. See Lincoln Savings, 403 U.S. at
354, 359. In so holding, the Court upheld the IRS's
distinction between payments that Lincoln made into the
FSLIC's "Primary Reserve," which the IRS had found to be
deductible as ordinary and necessary expenses, and those
payments made into the "Secondary Reserve," found to be
capital expenditures. The Court engaged in an extensive
analysis of the nature of each reserve fund and the
premium payments made into each by Lincoln Savings and
other similarly situated FSLIC-insured institutions. The
Court noted that the "only concern" was whether the
12
premium payment to the Secondary Reserve "was an
expense and an ordinary one within the meaning ofS 162(a)
of the Code." Lincoln Savings, 403 U.S. at 354. The Court
noted that the fact that many institutions were required to
make such a Secondary Reserve premium did not render
that premium an ordinary expense, see id. at 358; nor did
the fact that the premium could have some ensuing benefit
to Lincoln Savings, in and of itself, render the premium a
capital expenditure, see id. at 354 ("many expenses
concededly deductible have prospective effect beyond the
taxable year"). Rather, the Court focused on what the
payment represented in the context of Lincoln Savings'
business and of the "structure and operation of FSLIC's
reserves":
What is important and controlling, we feel, is that the
[Secondary Reserve] payment serves to create or
enhance for Lincoln what is essentially a separate and
distinct additional asset and that, as an inevitable
consequence, the payment is capital in nature and not
an expense, let alone an ordinary expense, deductible
under S 162(a) in the absence of other factors not
established here.
Id.12 Whereas Lincoln Savings and the other insured
institutions had no property interest in the Primary
Reserve, each did have an earmarked property interest in
the Secondary Reserve that was carried as an asset on each
institution's books, was enhanced by each institution's
contribution, and was refundable to that institution in
certain circumstances.
In the case at bar, the Tax Court concluded without any
elaboration that the consumer and commercial loans
"clearly" were separate and distinct assets of the banks, see
PNC, 110 T.C. at 364, and that the costs incurred in
originating and processing the loans "created" these
_________________________________________________________________
12. Interestingly, while the Court did not discuss the issue in terms of
the provisions of S 263, in determining that the asset was "capital in
nature," the Court necessarily engrafted its thinking on the meaning of
capital assets under that section of the Code. In fact, the Supreme Court
has subsequently described Lincoln Savings' holding as stemming from
an analysis of S 263 as well as S 162. See INDOPCO, 503 U.S. at 86-87.
13
separate and distinct assets, see id. at 366. We believe that
the Tax Court took too broad a reading of what Lincoln
Savings meant by "separate and distinct assets," as well as
an overbroad reading of what can be said to "create" such
assets.
The Secondary Reserve fund in Lincoln Savings was a
"separate and distinct asset" in two important ways that
distinguish it from FNPC's and UFB's loans, the assets in
question here. First, the Secondary Reserve fund was an
asset that existed quite apart from Lincoln's main daily
business of taking deposits and making loans; second, the
fund was an asset that, although it existed within the
FSLIC, was nonetheless separate from the FSLIC's other
revenues and distinctly earmarked as Lincoln's property.
The Tax Court's broad reading of Lincoln Savings essentially
treats the term "separate and distinct asset" as if it extends
to cover any identifiable asset. We do not subscribe to this
reading of Lincoln Savings.
Furthermore, we do not agree that the marketing and
origination activities actually "created" the banks' loans in
the same way that the activities in Lincoln Savings created
the Secondary Reserve fund. In the instant case, the Tax
Court proceeded from the clearly accurate premise that the
expenses in question were associated with the loans,
incurred in connection with the acquisition of the loans, or
"directly related to the creation of the loans," PNC, 110 T.C.
at 368, to the faulty conclusion that these expenses
themselves created the loans. See id. at 364-68. We
conclude that the term "create" does not stretch this far. In
Lincoln Savings, it was the payments themselves that
formed the corpus of the Secondary Reserve; therefore, it
naturally follows that these payments "created" the reserve
fund. In PNC's case, however, the expenses are merely
costs associated with the origination of the loans; the
expenses themselves do not become part of the balance of
the loan. PNC argues persuasively that the Tax Court's
interpretation of the Lincoln Savings language is
inappropriately expansive:
While purporting to apply the Lincoln Savings
language, both the Tax Court and the government
effectively have transformed that language, by subtle
14
but significant degrees, from a test based on whether
a cost "creates" a separate and distinct asset, into a
much more sweeping test that would mandate
capitalization of costs incurred "in connection with" or
"with respect to" the acquisition of an asset.
PNC Reply Br. at 4. We decline to follow the Tax Court's
broad interpretation, for to do so would be to expand the
type of costs that must be capitalized so as to drastically
limit what might be considered as "ordinary and necessary"
expenses. We conclude, therefore, that the loan origination
expenses were ordinary expenses and that they did not
"create or enhance a separate and distinct asset" within the
meaning of Lincoln Savings.
A line of federal appellate opinions subsequent to Lincoln
Savings, involving factual scenarios not that different from
the one before us, supports our finding that Lincoln Savings
does not compel a conclusion that FNPC's and UFB's costs
should be capitalized. These cases, from the Fourth, Eighth
and Tenth Circuit Courts of Appeals, address the
deductibility of costs incurred in connection with credit
card issuance. In Iowa-Des Moines National Bank v.
Commissioner, 592 F.2d 433 (8th Cir. 1979), the Eighth
Circuit Court of Appeals found that payments by banks to
third parties who provided the banks with credit
information on prospective credit card customers were
deductible expenses under S 162. See id. at 436. The court
found that "[p]erhaps the most significant factor is that the
payments were for a service (credit screening) that could
have been performed by personnel employed by the
[banks]." Id. Because "[c]redit screening is a necessary and
ordinary part of the banking business . . . not a capital
expenditure," the Eighth Circuit Court of Appeals found
that fees paid to third parties for credit screening were
deductible. Id. The Iowa-Des Moines court seemed to
assume that such expenditures would a fortiori be
deductible if the bank's personnel were to perform the
credit screens themselves.13 The Fourth and Tenth Circuit
_________________________________________________________________
13. The Eighth Circuit Court of Appeals also emphasized the "short
useful life" of this credit information as a factor weighing in favor of
deductibility. Iowa-Des Moines, 592 F.2d at 436.
15
Courts of Appeals have reached similar conclusions. In First
National Bank of South Carolina v. United States, 558 F.2d
721 (4th Cir. 1977) (per curiam), the Fourth Circuit Court
of Appeals permitted the taxpayer bank to deduct start-up
assessments paid to a nonprofit association formed to
enable banks to combine their efforts in entering the credit
card field. See id. at 723. The association was charged with
centralizing billing and recordkeeping for the banks. The
Fourth Circuit Court of Appeals characterized the credit
card accounts that were the focus of this activity as being
a type of loan. See id. at 722. In Colorado Springs National
Bank v. United States, 505 F.2d 1185 (10th Cir. 1974), the
Tenth Circuit Court of Appeals allowed the deduction of
pre-operation expenditures for a nonprofit credit card-
related association that would cover expenses such as
computer costs, advertising, credit screening, and clerical
services. See id. at 1193. The Colorado Springs court found
that these expenses did not "create or enhance . . . a
separate and distinct additional asset," reasoning as
follows:
The start-up expenditures here challenged did not
create a property interest. They produced nothing
corporeal or salable. They are recurring. At the most
they introduced a more efficient method of conducting
an old business. . . .
. . . [T]he use of bank credit cards in consumer
transactions is a normal part of the banking business.
The challenged expenditures were for the continuation
of an existing business and for the preservation and
improvement of existing income. Hence, they were
ordinary expenses.
Id. at 1192-93.
In the case before us, the Tax Court distinguished these
"credit card" cases, stating that they were inapposite to our
fact pattern because in those cases, no "separate and
distinct asset" was created, while in PNC's case, such an
asset was created. As we have discussed above, we do not
agree that the loan origination expenditures created distinct
assets, any more so than did the expenditures incurred in
entering into the credit card business. In fact, wefind that
16
PNC's situation presents an even stronger case for
deductibility than do the credit card cases. In the credit
card cases, the taxpayers were starting up new programs
within their businesses, or at the very least, new methods
of performing old tasks. In contrast, FNPC and UFB
incurred the challenged costs in their routine selling and
marketing of normal loans in the traditional ways that
banks have been using for many decades.14 Thus, FNPC's
and UFB's costs bear far more of the indicia of
"ordinariness," and fewer of the indicia of"creating"
something, than do the start-up costs described in the
credit card cases.
The remaining question, then, is whether either the
Financial Accounting Standards Board's adoption of SFAS
91 or the Supreme Court's pronouncement on deductibility
in INDOPCO, both of which developments occurred after the
decisions in Lincoln Savings and the credit card cases,
would alter the calculus of deductibility versus
capitalization in PNC's case. We conclude that the existence
of SFAS 91 has little, if any, bearing on the appropriate tax
analysis, and that the Supreme Court's decision in
INDOPCO, while clearly relevant, does not change the result
in the case at bar.
The Supreme Court has held that financial accounting
standards such as SFAS 91 do not dictate tax treatment of
income and expenditures. See Thor Power Tool Co. v.
Commissioner, 439 U.S. 522, 542-43, 544 (1979)
(discussing the "vastly different objectives thatfinancial and
tax accounting have" and stating that "[g]iven this diversity,
even contrariety, of objectives, any presumptive equivalency
between tax and financial accounting would be
unacceptable" and would "create insurmountable
difficulties of tax administration"). The IRS concedes that
"financial accounting rules are not controlling for federal
_________________________________________________________________
14. As the Tax Court decision that was affirmed by the Eighth Circuit
Court of Appeals in Iowa-Des Moines stated, costs that are "merely
related to the active conduct of an existing business and [do] not create
or enhance a separate and distinct asset or property interest" are
appropriate for deduction. Iowa-Des Moines Nat'l Bank v. Commissioner,
68 T.C. 872, 879 (1977), cited in PNC, 110 T.C. at 365.
17
tax purposes," IRS Br. at 28 n.4 (citing PNC , 110 T.C. at364 n.15), and states that "[n]either the Commissioner's
deficiency determination nor the Tax Court decision was
based on the provisions of SFAS 91," id. Although SFAS 91
may have served as a catalyst for the IRS's desire to seek
capitalization of the costs at issue here, and may have been
considered by the IRS in determining where to draw the
line between current-year and deferred costs, see supra
note 3, the IRS disavows any argument that the financial
accounting standards should dictate tax treatment, see IRS
Br. at 27-28 & n.4. Further, as with the financial
accounting standards at issue in Thor Power, it is clear that
the reasons for SFAS 91's requirement that loan origination
costs be deferred are reasons wholly specific to the realm of
financial accounting,15 and thus those financial accounting
standards do not affect our tax analysis.16
_________________________________________________________________
15. SFAS 91 was motivated by a concern that the structure of certain
banks' loan agreements could lead to the illusion that these banks and
their customers were in better financial condition than they actually
were. Specifically, SFAS 91 was designed to address the practices of
banks that charged unusually high fees up front as conditions for the
closing of a loan (e.g., high "points" on a mortgage) in exchange for
lower
interest rates later on; these practices were known as "teaser" rate
financing. See A. at 173. These practices"arguably allowed individuals
to qualify for loans in greater amounts than they would otherwise be
able to secure," id., and also overstated the income from a loan in its
first year and understated its income in later years. The Financial
Accounting Standards Board, concerned about these ramifications,
therefore required companies to defer fees over the life of the loan. SFAS
91 was worded to include the deferral of costs only after industry
representatives protested that it would be unfair to the industries to
have to defer the fees they received without also being allowed to defer
the costs they incurred. See A. at 174.
16. In fact, we conclude that the IRS's wholesale importation of the line
drawn by the financial accounting standards creates tax consequences
that the Commissioner appears not to have considered. For example, if
the loan origination costs were required to be capitalized, it would seem
to follow that these costs would have to be included in the basis of each
loan. Such inclusions would apparently be a departure from current
practice. Cf. Rev. Rul. 89-122, 1989-2 C.B. 200 (apparently assuming
that the bank's basis in a loan is equal to the money advanced by the
bank, without any adjustments for origination costs). The calculations
18
Nor do we view the Supreme Court's decision in INDOPCO
as requiring a different result regarding the deductibility of
the banks' costs. In INDOPCO, the Supreme Court required
capitalization of the expenditures incurred by the target
corporation during a planned friendly takeover by another
company. See INDOPCO, 503 U.S. at 90. The Supreme
Court was careful to emphasize in INDOPCO, as it had in
Lincoln Savings, that the capitalization versus deductibility
inquiry was heavily fact-based. See id. at 86 (citing Welch
v. Helvering, 290 U.S. 111, 114 (1933) and Deputy v. du
Pont, 308 U.S. 488, 496 (1940)). The Supreme Court in
INDOPCO downplayed the importance of the "creation of a
separate and distinct asset" described in Lincoln Savings,
clarifying that it was not an exclusive test:
Lincoln Savings stands for the simple proposition that
a taxpayer's expenditure that "serves to create or
enhance . . . a separate and distinct" asset should be
capitalized under S 263. It by no means follows,
however, that only expenditures that create or enhance
separate and distinct assets are to be capitalized under
S 263.
INDOPCO, 503 U.S. at 86-87. The Court reasoned that,
while in the Lincoln Savings setting the Court had seemed
to attach limited significance to the concept of"benefit," see
INDOPCO, 503 U.S. at 87 (quoting Lincoln Savings, 403
U.S. at 354), in the merger situation presented in INDOPCO
a "future benefit" analysis was relevant and appropriate
since the "resource-related benefits" to be reaped from the
merger were of considerable importance, INDOPCO , 503
U.S. at 88. In the INDOPCO context of a friendly takeover,
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involved would presumably complicate the transfer of loans from one
lending institution to another. However, the IRS conceded at oral
argument that a requirement of capitalization of loan origination costs
would probably mean that these complex basis adjustments would need
to be made. See Tr. of Oral Argument at 34. The IRS's apparent failure
to consider these and other tax ramifications of capitalization suggests
that the IRS's borrowing of the line that the SFAS 91 standards draw
between current-year costs and deferred costs was not based on any
independent tax analysis, but was simply a "bootstrapping" of the
financial accounting standards into the tax arena.
19
the Court found that one key inquiry was whether the
money that the target corporation had spent on takeover-
related expenditures was spent primarily for a "future
benefit" extending beyond the tax year, rather than for the
needs of current income production. The Court stated:
Although the mere presence of an incidental future
benefit -- "some future aspect" -- may not warrant
capitalization, a taxpayer's realization of benefits
beyond the year in which the expenditure is incurred is
undeniably important in determining whether the
appropriate tax treatment is immediate deduction or
capitalization.
Id. at 87.
As was recognized in several of the "credit card" cases
discussed above, these circumstances are simply not
presented by a bank's credit-issuing activities. The Eighth
Circuit Court of Appeals in Iowa-Des Moines, anticipating
the "future benefit" concerns later stated in INDOPCO,
emphasized the "short useful life" of credit information as a
reason for deductibility. Iowa-Des Moines, 592 F.2d at 436.
The Iowa court stated that the prospective future benefit
that could accrue beyond the taxable year as a result of
credit screening was "very slight," and thus capitalization
was "not easily supported." Id. In National Starch, the
decision that the Supreme Court affirmed in INDOPCO, we
found that these credit card cases contained the seed of the
"future benefit" analysis, citing these cases as evidence that
several Courts of Appeals "look[ed] to whether an ensuing
benefit was created to determine whether the expense was
ordinary and necessary," National Starch, 918 F.2d at 431,
and that these courts found that future benefit was not
substantial in situations similar to the case at bar. See id.(citing Iowa-Des Moines and Colorado Springs). We conclude
that the credit card cases not only continue to have vitality
after INDOPCO, but in fact anticipated some of the concerns
addressed by INDOPCO.
We also conclude that the Tax Court erred in its
interpretation of the "future benefit" analysis by relying on
the fact that the loan itself was usually of several years'
duration and by reasoning that the loan origination costs
20
were, thus, essentially directed at future benefit. The Tax
Court stated: "While the useful life of a credit report and
other financial data may be of short duration, the useful life
of the asset they serve to create is not." PNC, 110 T.C. at
371. However, that analysis depends on the Tax Court's
earlier assumption that the loan origination expenses
actually created a "separate and distinct asset." Stripped of
this assumption, the Tax Court's analysis is not
supportable.17
In addition, we must remember that the "future benefit"
analysis adopted in INDOPCO is not meant as a talismanic,
bright-line test. See A.E. Staley Mfg. Co. v. Commissioner,
119 F.3d 482, 489 (7th Cir. 1997) ("[T]he Court did not
purport to be creating a talismanic test that an expenditure
must be capitalized if it creates some future benefit.").
Rather, the INDOPCO analysis demonstrates the contextual,
case-by-case approach to determining whether an
expenditure better fits under the "ordinary and necessary"
language of section 162(a) or the "permanent improvements
or betterments" language of 263(a). We conclude that the
loan origination expenses incurred by UFB and FNPC have
the characteristics of the former, rather than the latter,
statutory language.
As described above, the loan marketing activities at issue
here lie at the very core of the banks' recurring, routine
day-to-day business. The Commissioner has not been able
to articulate a principled reason why these normal costs of
doing business must be capitalized, while other ordinary
banking costs need not be. Instead, the Commissioner
relies on the line drawn by SFAS 91, a standard whose
rationale we conclude is far removed from the concerns of
the tax system. See, e.g., IRS Br. at 27 ("It should be noted
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17. The Tax Court's "future benefit" discussion also reflects another
problematic assumption, i.e., that the capitalization requirement is
contingent on the loan's ultimately being approved. It cannot possibly be
true, as the Tax Court and the Commissioner would have it, that the
existence of a subsequent loan-derived revenue stream is the trigger for
the capitalization requirement. (If a company were to undertake research
and development to investigate new product lines, would it have to
capitalize only those R&D costs that led to product lines that were
ultimately successful and profitable? We think not.)
21
. . . that SFAS 91 itself, which the banks have followed,
expressly distinguishes direct loan origination costs, which
must be deferred, from all other loan-related costs, such as
advertising, soliciting potential borrowers, and servicing
existing loans, which may be currently deducted for
financial accounting purposes."); Tr. of Oral Argument at
27 (statement by IRS's counsel that "[w]here we draw the
line is -- actually the Financial Accounting Standards
Board made it very easy for us."). Similarly, the Tax Court,
while professing not to find the financial standards
dispositive, see PNC, 110 T.C. at 364 n.15, id. at 368 n.18,
used SFAS 91 as the sole source of an explanation as to
why these loan origination costs, but not other costs
associated with the banks' lending business, must be
capitalized, see id. at 368-69. We remain unconvinced that
the line drawn by the FASB in SFAS 91 has any relevance
here for tax purposes.
The Supreme Court has noted that "capitalization
prevents the distortion of income that would otherwise
occur if depreciation properly allocable to asset acquisition
were deducted from gross income currently realized."
Commissioner v. Idaho Power Co., 418 U.S. 1, 14 (1974). In
the case of the costs at issue here, there need be no
concern about a distortion of income because of the
regularity of these expenses.
Finally, we emphasize that the key to the deductibility
inquiry remains the statutory language of sections 162(a)
and 263(a). See Erwin N. Griswold, Cases and Materials on
Federal Taxation, at 15 (5th ed. 1960) ("There is no use in
thinking great thoughts about a tax problem unless the
thoughts are firmly based on the controlling statute."). The
analyses set forth in INDOPCO and Lincoln Savings provide
us with two applications of that statutory language. Like
the Supreme Court in INDOPCO and Lincoln Savings, we do
not here attempt to define once and for all a bright line
between deduction and capitalization that will hold true for
all factual situations. We can only heed Justice Cardozo's
admonition that we should always keep the factsfirmly in
view, as well as Dean Griswold's advice that we remain
cognizant of the language of the Code. Resorting to that
language, we find the case before us today to be much
22
farther from the heartland of the traditional capital
expenditure (a "permanent improvement or betterment")
than are the scenarios at issue in INDOPCO and Lincoln
Savings. We will not mechanistically apply phrases from
those precedents in ignorance of the realities of the facts
before us. We see no principled distinction between the
costs at issue here and other costs incurred as"ordinary
expenses" by banks.
V. Conclusion
For the foregoing reasons, we find that the loan
origination expenses are deductible as "ordinary and
necessary business expenses" under section 162(a) of the
Internal Revenue Code, and are not subject to the
capitalization provision of section 263(a). Accordingly, we
will reverse the judgment of the Tax Court.
A True Copy:
Teste:
Clerk of the United States Court of Appeals
for the Third Circuit
23