Indopco, Inc v. Commissioner of Internal Revenue

CourtUnited States Supreme Court
Citation117 L.Ed.2d 226,503 U.S. 79,112 S.Ct. 1039
Docket NumberNo. 90-1278,90-1278
PartiesINDOPCO, INC., Petitioner, v. COMMISSIONER OF INTERNAL REVENUE
Decision Date26 February 1992

503 U.S. 79
112 S.Ct. 1039
117 L.Ed.2d 226
INDOPCO, INC., Petitioner,

v.

COMMISSIONER OF INTERNAL REVENUE.

No. 90-1278.
Argued Nov. 12, 1991.
Decided Feb. 26, 1992.
Syllabus

On its 1978 federal income tax return, petitioner corporation claimed a deduction for certain investment banking fees and expenses that it incurred during a friendly acquisition in which it was transformed from a publicly held, freestanding corporation into a wholly owned subsidiary. After respondent Commissioner disallowed the claim, petitioner sought reconsideration in the Tax Court, adding to its claim deductions for legal fees and other acquisition-related expenses. The Tax Court ruled that because long-term benefits accrued to petitioner from the acquisition, the expenditures were capital in nature and not deductible under § 162(a) of the Internal Revenue Code as "ordinary and necessary" business expenses. The Court of Appeals affirmed, rejecting petitioner's argument that, because the expenses did not "create or enhance . . . a separate and distinct additional asset," see Commissioner v. Lincoln Savings & Loan Assn., 403 U.S. 345, 354, 91 S.Ct. 1893, 1899, 29 L.Ed.2d 519, they could not be capitalized under § 263 of the Code.

Held: Petitioner's expenses do not qualify for deduction under § 162(a). Deductions are exceptions to the norm of capitalization and are allowed only if there is clear provision for them in the Code and the taxpayer has met the burden of showing a right to the deduction. Commissioner v. Lincoln Savings & Loan Assn., supra, holds simply that the creation of a separate and distinct asset may be a sufficient condition for classification as a capital expenditure, not that it is a prerequisite to such classification. Nor does Lincoln Savings prohibit reliance on future benefit as means of distinguishing an ordinary business expense from a capital expenditure. Although the presence of an incidental future benefit may not warrant capitalization, a taxpayer's realization of benefits beyond the year in which the expenditure is incurred is important in determining whether the appropriate tax treatment is immediate deduction or capitalization. The record in the instant case amply supports the lower court's findings that the transaction produced significant benefits to petitioner extending beyond the tax year in question. Pp. 83-90.

918 F.2d 426 (CA3 1990) affirmed.

BLACKMUN, J., delivered the opinion for a unanimous Court.

Page 80

Richard J. Hiegel, New York City, for petitioner.

Kent L. Jones, Washington, D.C., for respondent.

Justice BLACKMUN delivered the opinion of the Court.

In this case we must decide whether certain professional expenses incurred by a target corporation in the course of a friendly takeover are deductible by that corporation as "ordinary and necessary" business expenses under § 162(a) of the federal Internal Revenue Code.

I

Most of the relevant facts are stipulated. See App. 12, 149. Petitioner INDOPCO, Inc., formerly named National Starch and Chemical Corporation and hereinafter referred to as National Starch, is a Delaware corporation that manufactures and sells adhesives, starches, and specialty chemical products. In October 1977, representatives of Unilever United States, Inc., also a Delaware corporation (Unilever),1 expressed interest in acquiring National Starch, which was one of its suppliers, through a friendly transaction. National Starch at the time had outstanding over 6,563,000 common shares held by approximately 3700 shareholders. The stock was listed on the New York Stock Exchange. Frank and Anna Greenwall were the corporation's largest shareholders and owned approximately 14.5% of the common. The Greenwalls, getting along in years and concerned about

Page 81

their estate plans, indicated that they would transfer their shares to Unilever only if a transaction tax-free for them could be arranged.

Lawyers representing both sides devised a "reverse subsidiary cash merger" that they felt would satisfy the Greenwalls' concerns. Two new entities would be created—National Starch and Chemical Holding Corp. (Holding), a subsidiary of Unilever, and NSC Merger, Inc., a subsidiary of Holding that would have only a transitory existence. In an exchange specifically designed to be tax-free under § 351 of the Internal Revenue Code, 26 U.S.C. § 351, Holding would exchange one share of its nonvoting preferred stock for each share of National Starch common that it received from National Starch shareholders. Any National Starch common that was not so exchanged would be converted into cash in a merger of NSC Merger, Inc., into National Starch.

In November 1977, National Starch's directors were formally advised of Unilever's interest and the proposed transaction. At that time, Debevoise, Plimpton, Lyons & Gates, National Starch's counsel, told the directors that under Delaware law they had a fiduciary duty to ensure that the proposed transaction would be fair to the shareholders. National Starch thereupon engaged the investment banking firm of Morgan Stanley & Co., Inc., to evaluate its shares, to render a fairness opinion, and generally to assist in the event of the emergence of a hostile tender offer.

Although Unilever originally had suggested a price between $65 and $70 per share, negotiations resulted in a final offer of $73.50 per share, a figure Morgan Stanley found to be fair. Following approval by National Starch's board and the issuance of a favorable private ruling from the Internal Revenue Service that the transaction would be tax-free under § 351 for those National Starch shareholders who ex-

Page 82

changed their stock for Holding preferred, the transaction was consummated in August 1978.2

Morgan Stanley charged National Starch a fee of $2,200,000, along with $7,586 for out-of-pocket expenses and $18,000 for legal fees. The Debevoise firm charged National Starch $490,000, along with $15,069 for out-of-pocket expenses. National Starch also incurred expenses aggregating $150,962 for miscellaneous items such as accounting, printing, proxy solicitation, and Securities and Exchange Commission fees—in connection with the transaction. No issue is raised as to the propriety or reasonableness of these charges.

On its federal income tax return for its short taxable year ended August 15, 1978, National Starch claimed a deduction for the $2,225,586 paid to Morgan Stanley, but did not deduct the $505,069 paid to Debevoise or the other expenses. Upon audit, the Commissioner of Internal Revenue disallowed the claimed deduction and issued a notice of deficiency. Petitioner sought redetermination in the United States Tax Court, asserting, however, not only the right to deduct the investment banking fees and expenses but, as well, the legal and miscellaneous expenses incurred.

The Tax Court, in an unreviewed decision, ruled that the expenditures were capital in nature and therefore not deductible under § 162(a) in the 1978 return as "ordinary and necessary expenses." National Starch and Chemical Corp. v. Commissioner, 93 T.C. 67 (1989). The court based its holding primarily on the long-term benefits that accrued to National Starch from the Unilever acquisition. Id., at 75. The United States Court of Appeals for the Third Circuit affirmed, upholding the Tax Court's findings that "both Unilever's enormous resources and the possibility of synergy arising from the transaction served the long-term better-

Page 83

ment of National Starch." National Starch and Chemical Corp. v. Commissioner, 918 F.2d 426, 432-433 (1990). In so doing, the Court of Appeals rejected National Starch's contention that, because the disputed expenses did not "create or enhance . . . a separate and distinct additional asset," see Commissioner v. Lincoln Savings & Loan Assn., 403 U.S. 345, 354, 91 S.Ct. 1893, 1899, 29 L.Ed.2d 519 (1971), they could not be capitalized and therefore were deductible under § 162(a). 918 F.2d, at 428-431. We granted certiorari to resolve a perceived conflict on the issue among the Courts of Appeals.3 --- U.S. ----, 111 S.Ct. 2008, 114 L.Ed.2d 96 (1991).

II

Section 162(a) of the Internal Revenue Code allows the deduction of "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." 26 U.S.C. § 162(a). In contrast, § 263 of the Code allows no deduction for a capital expenditure—an "amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate." 26 U.S.C. § 263(a)(1). The primary effect of characterizing a payment as either a business expense or a capital expenditure concerns the timing of the taxpayer's cost recovery: While business expenses are currently deductible, a capital expenditure usually is amortized and depreci-

Page 84

ated 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. See 26 U.S.C. §§ 167(a) and 336(a); Treas.Reg. § 1.167(a), 26 CFR § 1.167(a) (1991). Through provisions such as these, the Code endeavors to match expenses with the revenues of the taxable period to which they are properly attributable, thereby resulting in a more accurate calculation of net income for tax purposes. See, e.g., Commissioner v. Idaho Power Co., 418 U.S. 1, 16, 94 S.Ct. 2757, 2766, 41 L.Ed.2d 535 (1974); Ellis Banking Corp. v. Commissioner, 688 F.2d 1376, 1379 (CA11 1982), cert. denied, 463 U.S. 1207, 103 S.Ct. 3537, 77 L.Ed.2d 1388 (1983).

In exploring the relationship between deductions and capital expenditures, this Court has noted the "familiar rule" that "an income tax deduction is a matter of legislative grace and that the burden of clearly showing the right to the claimed deduction is on the taxpayer." Interstate Transit Lines v....

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