PNC Bancorp v. Comm'r of Internal Revenue, 95-16002

• Decision Date: 19 May 2000
• Docket Number: No. 99-6020,No. 96-16110,No. 96-16109,No. 95-16002,No. 95-16003,95-16002,95-16003,96-16109,96-16110,99-6020
• Citation: 212 F.3d 822
• Parties: (3rd Cir. 2000) PNC BANCORP, INC., Successor to First National Pennsylvania Corporation v. COMMISSIONER OF INTERNAL REVENUE (Tax Court) PNC BANCORP, INC., Transferee of Assets of First National Pennsylvania Corporation v. COMMISSIONER OF INTERNAL REVENUE (Tax Court) PNC BANCORP, INC., Successor to United Federal Bancorp, Inc., and Subsidiaries v. COMMISSIONER OF INTERNAL REVENUE (Tax Court) PNC BANCORP, INC., Transferee of Assets of United Federal Bancorp, Inc., and Subsidiaries v. COMMISSIONER OF INTERNAL REVENUE (Tax Court) 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
• Court: U.S. Court of Appeals — Third Circuit

Page 822

212 F.3d 822 (3rd Cir. 2000)

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

No. 99-6020

UNITED STATES COURT OF APPEALS FOR THE THIRD CIRCUIT

Argued October 21, 1999

Filed May 19, 2000

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

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

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

Before: SLOVITER, RENDELL, Circuit Judges, and BYRNE, District Judge^*

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 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 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.

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 ^PC 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 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 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 "crosssales" 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...