Sprint Corporation and Subsidiaries, f.k.a. United Telecommunications, Inc. v. Commissioner ( 1997 )

108 T.C. No. 19UNITED STATES TAX COURT
SPRINT CORPORATION AND SUBSIDIARIES,
F.K.A. UNITED TELECOMMUNICATIONS, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 13159-94. Filed April 30, 1997.
P, a telephone company, purchased certain
telecommunications equipment, digital switches, that
required computer software to operate. P claimed
investment tax credits (ITC) and depreciation
deductions under the accelerated cost recovery system
(ACRS) with respect to the total cost of each digital
switch, which included the cost of the software used in
each switch. R determined that P's expenditures
allocable to the software did not qualify for the ITC
or depreciation under the ACRS.
P treated property known as “drop and block” as
5-year property, as defined in sec. 168(c)(2)(B),
I.R.C. R determined that the property was 15-year
public utility property. For the years in issue, the
property was depreciated under the ACRS.
1. Held: P's expenditures allocable to the
software qualify for the ITC and depreciation under the
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ACRS. Norwest Corp. & Subs. v. Commissioner, 108 T.C.
___ (1997), is followed.
2. Held, further: Drop and block is 5-year
property under sec. 168(c)(2)(B), I.R.C.
Jay H. Zimbler, Michael A. Clark, Michael R. Schlessinger,
and William J. McKenna, Jr., for petitioner.
Alan M. Jacobson, John W. Duncan,and Patricia Pierce Davis,
for respondent.
HALPERN, Judge: Respondent determined deficiencies in
petitioner's Federal income taxes for the years and in the
amounts as follows:
Year Deficiency
1982 $7,400,722
1983 39,996
1984 318,791
1985 157,987
Sprint Corporation (Sprint or petitioner) is a Kansas
corporation with its principal office in Westwood, Kansas.
Formerly known as United Telecommunications, Inc., petitioner
officially changed its name to Sprint Corporation as of February
26, 1992. Unless otherwise noted, references herein to Sprint
and petitioner will include the period during which petitioner
was known as United Telecommunications, Inc. Petitioner filed
consolidated Federal income tax returns for itself and its
eligible subsidiaries for the 1982, 1983, 1984, and 1985 taxable
years.
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After concessions by the parties, the issues remaining for
decision are (1) whether certain expenditures made by petitioner
during the years in issue that are allocable to the cost of
computer software used in central office equipment (COE or
digital switches) qualify for the investment tax credit (ITC) and
depreciation under the accelerated cost recovery system (ACRS)
and (2) the proper classification as recovery property of certain
telecommunications equipment known as “drop and block”. Unless
otherwise noted, all section references are to the Internal
Revenue Code in effect for the years in issue, and all Rule
references are to the Tax Court Rules of Practice and Procedure.
FINDINGS OF FACT1
During the taxable years in issue, petitioner and its
subsidiaries were engaged in the business of providing local and
long-distance telephone service. Petitioner generally operated
its business of providing telephone service through separately
incorporated, wholly owned subsidiaries. The local companies are
generally known by names indicating the parent company and their
geographic location (e.g., United of Iowa or UT of Florida) and
will be so referred to herein where reference to a specific
subsidiary is necessary. In all other instances, references to
1
The stipulation of facts and accompanying exhibits are
incorporated herein by this reference. The trial Judge made the
following Findings of Fact, which we adopt.
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Sprint and petitioner shall be deemed to include petitioner's
subsidiaries.
A. The Digital Switch Issue
The equipment that provides the switching function that
enables one telephone subscriber to connect to another has
undergone an evolution from its earliest form, when the switching
function was performed by human operators sitting at manual
switchboards. Manual switching was automated with the advent of
electromagnetic relay switches. Since 1980, switching in the
United States has increasingly been done by digital switches
consisting of a number of integrated circuits, clocks,
processors, and central processing units (hardware). Digital
switches operate in accordance with programmed instructions
initially encoded on magnetic tape (software). The central
processing units are specially designed computers that are used,
and can only be used, to control the switch function.
During the years in issue, petitioner purchased from
different vendors several digital switches (hardware and
software) for use in its telephone business, generally to replace
existing electromechanical switches. Investment tax credits and
depreciation deductions under the ACRS were claimed with respect
to the total cost of each switch. In the notice of deficiency,
respondent disallowed that portion of the claimed investment tax
credits and accelerated depreciation deductions relating to the
costs of the software.
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General Background
Broadly, the three basic components of a telecommunications
system are station equipment, transmission facilities, and
switches. Station equipment is generally located on the
customer's premises and includes such items as the telephone at a
residential customer's house. Transmission facilities provide
the paths over which information is transmitted between customers
(whether the medium is used for local network transmission or
transmission over trunks, which are lines between different
networks) and consist of transmission media such as copper and
fiber optic cable, as well as the equipment used to amplify and
regenerate the transmitted signals. Switches connect
transmission facilities at key locations and route incoming and
outgoing calls.
The basic objective of the telephone switch is to connect
any calling outlet with any wanted inlet, a process that can be
visualized by picturing an operator sitting at an old manual
switchboard. As a call is made, the operator pulls a flexible
cord connected to the caller's line and physically plugs it into
a receptacle connected to another line in the same network or to
a trunk line if the recipient is in a different network.
The process of switching actually involves four sequential
phases, each consisting of certain activities or functions. The
first phase, preselection, encompasses activities related to
recognizing a new call request and determining how to route it.
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The second phase of switching is call completion, which entails
the actual connection of the requesting outlet to the wanted
inlet utilizing the determined routing, and initiation of the
charging process. The third phase of switching is conversation.
The fourth and final phase is release, which is the disconnection
of the call, completion of the charge record, and restoration of
the network to the normal (idle) state.
In addition to switching activities, modern switching
equipment must also perform certain management functions (such as
automatically detecting and isolating system and component
malfunctions), as well as provide certain customer services (such
as call forwarding or coin return at a pay telephone when the
call is not completed).
The implementation of the various activities and functions
of the switching process is complicated by certain system
requirements, including availability, reliability, privacy, and
economy, which at times may conflict with one another. The first
requirement, availability, refers to the need to have sufficient
paths so that a connection can be made on demand. The
reliability requirement refers to the need to assure that the
system as a whole, or a particular connection, does not go down
(fail). The privacy requirement reflects the need to switch
correctly (to the desired customer exclusively) or not at all.
Intentional misconnections, such as those caused by attempts to
avoid proper charging, as well as accidental misconnections, must
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be prevented. The economy requirement refers to the need to
provide service at a competitive price. To that end, it is
necessary to avoid overbuilding a system despite the desire for
availability, reliability, and privacy. Availability and
privacy, which generally are presumed requirements, voice
quality, price, and reliability are the bases by which systems
compete, with reliability being the key differentiating basis.
The reliability standards for telephone switches are far more
stringent than for most modern computer systems.
An automated telephone switch comprises (1) the switching
network, (2) various interfaces, and (3) control mechanisms. The
heart of the switch is the network, which consists of individual
devices designed to connect (and disconnect) communication paths.
Before integrated circuit switching, automated switching was
accomplished through a series of electromagnetic relays. When a
call was placed, a physical connection path would be formed by
closing the appropriate relays. In its most simplified form,
i.e., a network system consisting of only two telephone
customers, the operation of the switch would involve nothing more
than closing and opening the relay switch on the line running
between the two customers. When the relay was closed, the lines
of the two customers would be connected and the switch would have
functioned, enabling conversation.
A local telephone system may consist of hundreds of
thousands of customers. It would be cost prohibitive either to
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connect each subscriber directly to every other subscriber or to
have a centralized switch within a network with the same number
of direct lines as there are combinations of customers. Rather,
to satisfy the economic considerations of a telephone system, the
switch function in a given area is centralized at an office (the
central office), which receives calls placed by customers and
then routes those calls through one of a number of outlets to
other subscribers within the local network or to other local
networks via long-distance trunks.
The earliest automated switching systems used direct
progressive control to operate the switch, whereby relay switches
along the path connecting the calling and the called parties
would be closed as each digit in a telephone number was dialed
until a complete connection was made.
To address certain disadvantages of progressive control
systems, telephone designers in the 1940s began incorporating
registers, devices which store and release dialed telephone
numbers into telephone switches. Using registers, systems could
be devised for looking ahead to ascertain the best possible
routing. Moreover, with such use, common control, or control of
various telephone functions by a centralized mechanism shared by
separate lines, was possible. By the 1950s, switches used
electromechanical switches and relays to accomplish the key
control functions of a switch on a common basis, including
determining routing, seizing trunk lines, and ringing the call
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user. Even identifying, measuring, and recording a long-distance
toll call was accomplished through common control mechanical
devices.
With the advent of solid-state electronics, some or all of
the common control functions were accomplished by utilizing
integrated circuits on which processing (control) instructions
were encoded. Instead of electromechanical devices opening and
shutting in a predetermined (programmed) fashion to respond to
various alternative situations, electronic circuits would be
opened or closed in accordance with the embedded logic.
In the mid-1960s, new telephone switches began to use
specially designed processors called stored program control
(SPC), which execute programs encoded on magnetic tape or other
media, rather than wired-logic, to control certain switch
functions. At first, the tendency in digitalized switch design
was to centralize most switch control functions in one central
processing unit. By the end of 1985, it was deemed more
beneficial if certain control functions were performed by
decentralized processors controlled by the central processing
unit.
The advantages of SPC were that, because its program was
loaded by tape, rather than in electromechanical devices or
hard-wired integrated circuits, the program could be more easily
maintained (or changed), and the speed of electronics could be
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more easily harnessed to allow a large network to be controlled
by a single high-speed processor.
Design and Architecture of the Modern Digital Switch
Modern digital switches are designed from the ground up by a
handful of manufacturers around the world. In the 1980s, the
major North American manufacturers were ITT Corp., Northern
Telecom, Inc. (NTI), American Telephone & Telegraph Co., GTE
Corp., TRW Vidar, Inc., and Stromberg Carlson, Inc.
Beginning in the late 1970s, engineers designing a
particular model of a switch did not merely arrange standard
electronic components into a standard structure. Rather, a
particular overall structure was conceived, and then the
components of each of the interfaces, the network devices, and
the control mechanisms (including the encoded program) were
specially engineered in the context of that concept. As a result
of design choices and the proprietary nature of certain custom
designed components (many of which are patented), the
architecture of a modern digital switch produced by one
manufacturer differed (and still differs) significantly from the
architecture of a switch produced by another.
Because each switch was designed for the particular
parameters (number of subscribers, usage patterns, potential for
growth) of a given central office location, there could be
differences in architecture between switches produced by the same
manufacturer but installed in two different locations.
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In addition to choices between the actual logic, engineers
designing the encoded programs for the control mechanisms of a
modern digital switch also had the option to place various parts
of the encoded logic in software (i.e., the encoded medium that
will be loaded into the central processing unit) or firmware
(permanently encoded chips located in the central processing unit
or in microprocessors located throughout the switch). The
choices made were determined to a large extent by the switch's
architecture. A switch manufacturer writes the programs and
decides how they would be incorporated into the processors in the
context of the design requirements of a particular model. Just
as the architecture of the switch affects the programming, the
programming limitations and requirements affect the architecture
of the switch. The programming is also affected by the given
location. Due to the unique parameters of a given location,
programs are invariably location specific.
Because of the interrelationship of the architecture and
programming and the unwillingness of manufacturers to sell the
switch hardware without the switch software, programming for a
digital switch is written by the manufacturer of the switch and
is not available from third parties. Absent the manufacturer's
programming, the manufacturer's hardware cannot operate. Because
the design of the programming is specific to the architecture and
even the location of the digital switch, not only can the
programming of one manufacturer not be used on the equipment of
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another, but the programming of a switch in one location
generally cannot be used on a switch of the same type in another
location.
Digital Switch Acquisitions (1982-85)--Generally
The particular design of the digital switches acquired by
Sprint during the years in issue varied from manufacturer to
manufacturer and from model to model. However, the facts
relating to the DMS-100, manufactured by NTI, including its
acquisition and software, are representative of the purchases in
issue.
Although there were many design configurations and
software/firmware combinations, none of that concerned
petitioner, which was interested in a turnkey switch; that is,
Sprint desired that the vendor would engineer, furnish, install,
and prepare a complete switch for service. Sprint's primary
purpose in the procurement process was to determine which
manufacturer could satisfy petitioner's requirements for the
lowest price. Based on those criteria, Sprint selected a
manufacturer and negotiated a final price.
Once an agreement was reached, a software load for the
switch was developed by the manufacturer, NTI in this instance.
First, NTI technicians reviewed Sprint's order to ascertain the
number of lines and trunks and the types of desired features and
prepared a written plan or blueprint to be used in compiling the
software load. The software load was then made by downloading a
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base load module from a software library onto a blank magnetic
tape, pulling down other existing modules from the software
library to meet design specifications, and manually installing
various “data information” and translation codes onto the tape.
Three copies of the software load were made, two being sent to
Sprint and one being retained solely for safety reasons by NTI.
NTI technicians then installed the custom software load on the
particular switch for which it was designed. Once installed, the
custom software load was tested and validated by NTI technicians.
An invoice from NTI indicates that, on a particular switch, of
532 total hours to develop the software load, 500 hours were
spent writing the software blueprint and testing and validating
the installed software. There was little or no time actually
spent writing new software for the digital switch, and there was
no evidence as to how many preexisting modules were used.
Once the equipment became operational, software load updates
were periodically provided by the manufacturers. If there was a
new feature to be added, it was done at the time of the periodic
update. The time required to effect those modifications varied
between 100 and 160 man-hours. If the hardware of the switch was
moved to a different geographic location, a new custom software
load would be prepared utilizing the same steps.
Nature of Sprint's Possession of the Software
The direct sales agreement between petitioner and NTI
provided a warranty as to the software loads. Provided that
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Sprint adequately maintained the equipment, NTI warranted that
the software would function in accordance with the specifications
applicable on the shipment date, and, upon its failure to do so,
NTI would correct the failure and act to ensure that the software
was operating as specified.
Section 8 of the sales agreement, labeled “Software
License”, provided that Sprint was granted a nonexclusive paid-up
license to use the software for its intended purpose, as long as
the switch was in use. Software is defined as computer programs
contained on a magnetic tape, disk, semiconductor device, or
other memory device or system memory. Sprint agreed that the
software provided by NTI was to be treated as the exclusive
property of NTI. To that end, Sprint promised to hold the
software in confidence for the benefit of NTI; not provide or
make the software available to any person except to its employees
on a “need to know” basis; not modify the software; not reproduce
or copy the software in whole or in part; and return to NTI any
magnetic tape, disk, semiconductor device or other memory device
or system, and documentation or other material, which had been
replaced, modified, or updated. Sprint was not required to
protect NTI's interest in any data or information that became
available to the general public, commonly known as “public
domain” software. In the event that NTI modified or changed the
software to permit additional features or services, the updated
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software was to be made available to Sprint at NTI's then-current
price for those features or services.
Although there were significant limitations on Sprint's
rights in the software, under section 8.6 of the sales agreement,
Sprint was given the right, upon transfer of title to the digital
switch, to assign the license for the software or, upon a lease
or other nonpermanent transfer, sublicense the software, provided
the assignee or sublicensee agreed in writing to the above terms.
Around 1988 or 1989, Sprint effected a trade of title of
approximately 30 DMS-100 type digital switches with ConTel Co.,
another telephone company. None of the switches were actually
moved, and service to the customers was not interrupted.
Although neither party specifically notified NTI, the trade
received sufficient attention in the industry to give NTI at
least constructive notice of the trade. NTI did not object to
the trade.
Respondent determined in the notice of deficiency that the
costs of the software are not eligible for either the ITC or
accelerated depreciation under the ACRS because (1) Sprint
received a license to use the software rather than owning the
software and (2) in any event, the software is not tangible
property.
Sprint acknowledges that the substantial value of encoded
programming on software, in general, relates to the programming's
conceptual or intangible value, but nonetheless contends that
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(1) Sprint owned the software in issue and (2) the software
qualifies as tangible personal property.
Respondent concedes that if Sprint in fact owned the
software and the software constitutes tangible property, Sprint
is entitled to the ITC and accelerated depreciation, as claimed.
If Sprint did not own the software in issue, or if the software
is not tangible personal property, respondent contends that
Sprint is entitled to amortize the cost of the software on a
straight-line basis over an 18-year period, while Sprint contends
that the costs should be amortized in accordance with Rev. Proc.
69-21, sec. 4.01(2), 1969-2 C.B. 303. The 18-year period is the
class life asset depreciation range (CLADR) midpoint life of the
switch hardware with which the software is associated. Rev.
Proc. 69-21, sec. 4.01(2), supra, is the procedure pursuant to
which, during 1982 through 1985, Sprint capitalized and amortized
the cost of purchased software, other than the software purchased
in connection with the digital switches (rather than claiming the
ITC and accelerated depreciation under the ACRS).
B. Drop and Block Issue
A telephone network includes transmission facilities and
station equipment (or station apparatus). Transmission
facilities consist of the wiring and ancillary equipment used to
transmit telephone signals between the telephone company's
central office and the customer's (whether caller or callee)
station apparatus (i.e., telephone, modem, or other device).
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Transmission facilities consist of three distinct segments:
(1) the main cable, either buried or aerial, (2) the wire (drop
wire) running from the distribution network to and including the
station protector (also known as the block) located on the
outside wall of the customer's premises (together the “drop and
block”), and (3) the wire running from the station protector to
and around the inside of the customer's premises (the inside
wiring).
As a public utility, the telephone industry is regulated by
the Federal Communications Commission (FCC). As part of its
regulatory function, the FCC prescribes the accounting treatment
of revenues earned and expenses incurred in the operation of a
telephone business. The relevant rules are set forth in 47
C.F.R. part 31 (part 31), Uniform System of Accounts for Class A
and Class B Telephone Companies. During the years in issue, all
of petitioner's subsidiaries were telephone companies subject to
part 31 rules.
As of January 1, 1981, part 31 specified that the investment
in drop and block be accounted for in FCC account No. 232
(station connections). As of January 1, 1981, and in accordance
with part 31, petitioner so accounted for its investment in drop
and block. Beginning January 1, 1984, part 31 was changed and
specified that investment in drop and block be accumulated in FCC
account No. 242 (aerial and buried cable). For income tax
purposes, petitioner treated property in FCC account No. 232 as
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depreciable over 5 years and property in FCC account No. 242 as
depreciable over 15 years. In petitioner's 1984 and 1985 Federal
income tax returns, the following subsidiaries of petitioner
continued to account for drop and block in FCC account No. 232,
treating it as 5-year property for depreciation purposes:
Company
UT of PA & Saltillo Carolina T&T
UT of New Jersey UT of Florida
New Jersey Tel. Co. United Intermountain
West Jersey Tel. Co. UT of Carolinas
Hillsborough-Montgomery UT of Indiana
Sussex Tel. Co. (D) UT of the Northwest
UT of Ohio UT Texas & Palo Pinto
In petitioner's 1984 and 1985 Federal income tax returns,
the following subsidiaries of petitioner accounted for drop and
block in FCC account No. 242, treating it as 15-year public
utility property for depreciation purposes:
Company
UT Arkansas
UT Iowa
UT Kansas
UT Minnesota
UT Missouri
UT West
Respondent concedes that, if the drop and block property
placed in service during the years in issue is properly
classified by reference to its pre-January 1, 1984, inclusion in
FCC account No. 232 and CLADR Asset Guideline Class 48.13, then,
with the exception of the depreciation described in the preceding
paragraph, the depreciation claimed with respect to that drop and
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block per return as filed was correct; petitioner is then
entitled to adjustments increasing depreciation for the companies
listed in the preceding paragraph for which drop and block was
treated as 15-year public utility property on petitioner's
Federal income tax returns as filed for 1984 and 1985.
Petitioner concedes that, if the drop and block placed in
service during the years in issue is properly classified by
reference to its post-December 31, 1983, inclusion in FCC account
No. 242 and CLADR Asset Guideline Class 48.14, then the
depreciation claimed by petitioner in its Federal income tax
returns for 1984 and 1985 with respect to such drop and block
would be reduced, with the result that taxable income would be
increased with respect to the companies which treated the drop
and block as 5-year property.
OPINION
I. Digital Switches
A. Introduction
Petitioner purchased central office equipment (COE or
digital switches) for use in its business of providing telephone
service. Petitioner claimed investment tax credits (ITC) and
depreciation deductions under the accelerated cost recovery
system (ACRS) with respect to the total cost of each digital
switch, which included the cost of the custom computer software
load (software load) necessary to make each switch operable. In
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the notice of deficiency, respondent disallowed that portion of
the claimed investment tax credits and accelerated depreciation
deductions relating to the costs of the software loads.
The parties agree that, if this Court determines that
petitioner owned the software loads in issue and that those
software loads constitute tangible personal property, petitioner
is entitled to the claimed investment tax credits and accelerated
depreciation deductions. We conclude that petitioner owned the
software loads in issue and that those software loads constitute
tangible personal property. Therefore, we hold that petitioner
is entitled to the claimed credits and deductions.
B. Analysis
Today, in Norwest Corp. & Subs. v. Commissioner, 108 T.C.
___, ___ (1997) (slip op. at 27), we decided that operating and
applications software that was subject to license agreements
entitling the taxpayer to use the software on a nonexclusive,
nontransferable basis for an indefinite or perpetual term
qualifies for the ITC as tangible personal property. In holding
that the taxpayer's acquisition of the software without any
associated, exclusive, intangible intellectual property rights
was precisely the type of investment Congress intended to
encourage in enacting the ITC, we noted that “[i]ntangible
intellectual property rights and the tangible or physical
manifestations or embodiments of those rights are distinct
property interests.” Id. at ___-___ (slip op. at 26-27) (citing
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17 U.S.C. sec. 202 (1994)). We see no material distinction
between the software in the Norwest case and the software loads
in issue here. In this case, however, respondent has raised the
question of whether petitioner acquired sufficient benefits and
burdens of ownership with respect to the software loads to be
considered the owner of those loads for purposes of the ITC and
the ACRS.
The parties agree that the issue of ownership of the
software loads is governed by the substance of the sales
agreements between petitioner and the various digital switch
manufacturers, not the labels used in those agreements. See,
e.g., Tomerlin Trust v. Commissioner, 87 T.C. 876, 881-883
(1986); see also Leahy v. Commissioner, 87 T.C. 56, 66 (1986)
(transfer of the benefits and burdens of ownership govern for
Federal tax purposes, rather than the technical requirements of
passage of title under State law). The parties also agree that
the direct sales agreement between petitioner and Northern
Telecom, Inc. (NTI), in effect from January 1, 1983, to
December 31, 1985 (the Sprint/NTI agreement), is representative
of all of the agreements pursuant to which petitioner acquired
the digital switches in issue. Therefore, we must determine
whether petitioner owned the software load transferred by NTI to
petitioner (the NTI software load). Whether petitioner became
the owner of the NTI software load is a question of fact to be
ascertained by reference to the Sprint/NTI agreement, read in
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light of the attending facts and circumstances. See, e.g., Grodt
& McKay Realty, Inc. v. Commissioner, 77 T.C. 1221, 1237 (1981).
Petitioner acquired from NTI magnetic tapes containing
copies of the computer software necessary to make the digital
switch operable, i.e., the NTI software load, and did not acquire
any of the underlying, exclusive, intangible intellectual
property rights. See, e.g., 17 U.S.C. sec. 101 (1994) (a
nonexclusive license is not within the definition of the term
“transfer of copyright ownership”). Petitioner possessed all of
the significant benefits and burdens of ownership with respect to
those magnetic tapes. NTI simply did not retain a residuary
interest in the NTI software load commensurate with an interest
typically retained by a lessor of property. See Crooks v.
Commissioner, 92 T.C. 816, 819 (1989) (“interest retained by the
transferor is the primary distinction between a sale and a
lease”).
First, petitioner paid a fixed amount for the digital
switch, which included the cost allocable to the NTI software
load, and did not incur any obligation to make further payments
for that load, contingent or otherwise. More importantly,
petitioner acquired the exclusive right to use the NTI software
load for the useful life of the digital switch, which was
tantamount to acquiring the perpetual right to use that
particular load because of the interrelationship between the
switch hardware and software. In addition, petitioner had the
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right to transfer the software load in conjunction with a
transfer of the digital switch without NTI's consent. Respondent
attempts to characterize that right as a “right without
substance” because any new owner of the digital switch would have
to acquire a new software load, unless the switch was used in the
same location. That condition, however, appears relatively
unrestrictive in light of Sprint's trade of approximately 30
similar digital switches with ConTel Co., in the late 1980s,
which resulted in none of the switches actually changing
location. Lastly, the Sprint/NTI agreement provided that the
risk of loss with respect to the digital switch, including the
NTI software load, would pass to petitioner upon delivery.
Respondent points to certain provisions in the Sprint/NTI
agreement as evidence that the benefits and burdens of ownership
did not pass from NTI to petitioner. In particular, respondent
focuses on certain provisions in the Sprint/NTI agreement that
provide that the software transferred with the digital switch
manufactured by NTI was to be treated as the exclusive property
and trade secret of NTI and that petitioner was under certain
obligations to protect NTI’s interest in the software. The
provisions of the Sprint/NTI agreement cited by respondent all
relate to NTI’s interest in the intellectual property underlying
the NTI software load. Those provisions protect, reinforce, and
extend NTI’s intellectual property rights in that software.
NTI’s retention of those rights is consistent with the conclusion
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that petitioner owned the NTI software load. Cf. Conde Nast
Publications, Inc. v. United States, 575 F.2d 400, 407 (2d Cir.
1978) (limitations on transferee's rights in subject property
that serve only to protect transferor's interest in other
property do not divest transferee of ownership). Although those
provisions created certain obligations with respect to
petitioner's ownership of the NTI software load, such as holding
that load in confidence and only making that load available to
employees on a “need to know” basis, petitioner’s ownership
interest in that particular load remained intact. Moreover, many
of the restrictions imposed on petitioner's use of that load were
also imposed on the technical and proprietary information
relating to the digital switch hardware; apparently, however,
respondent does not question petitioner's ownership of that
hardware.
In sum, petitioner acquired from NTI all of the significant
benefits and burdens of ownership with respect to the NTI
software load. The limitations on petitioner's use of that load
served only to protect NTI's underlying intellectual property
rights and did not divest petitioner of ownership in that
particular load. We find that petitioner owned the NTI software
load and did not purchase any exclusive, intangible intellectual
property rights underlying that load. In accordance with the
parties' agreement and our holding in Norwest Corp. & Subs. v.
Commissioner, 108 T.C. ___ (1997), we hold that petitioner owned
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all of the software loads used in all of the digital switches in
issue and that those software loads constitute tangible personal
property for purposes of the ITC and the ACRS.2 Therefore,
petitioner is entitled to the claimed investment tax credits and
accelerated depreciation deductions.
II. The Drop and Block Issue
A. Introduction
The drop and block portion of petitioner's telephone network
consists of the wire running from petitioner's transmission
network to a station protector located on the outside of a
customer's premises. We must determine the depreciation class of
the drop and block for purposes of the ACRS.
2
In accordance with Norwest Corp. & Subs. v. Commissioner,
108 T.C. ___ (1997), we hold today that the software loads in
issue constitute tangible personal property for purposes of the
investment tax credit (ITC) and tangible property for purposes of
the accelerated cost recovery system (ACRS). Although respondent
does not assert that there exists a distinction in the meaning of
the term “tangible” as it is used in the term “tangible personal
property” for purposes of the ITC and the term “tangible
property” for purposes of the ACRS, we believe that our reliance
on the legislative history of the ITC in Norwest requires at
least a brief discussion of that issue.
As a preliminary matter, sec. 168 and the regulations
thereunder do not define the term “tangible property” for
purposes of the ACRS. Sec. 168, which implements the ACRS, was
enacted by the Economic Recovery Tax Act of 1981 (ERTA), Pub. L.
97-34, sec. 201, 95 Stat. 203. The relevant committee reports
accompanying the enactment of ERTA indicate that Congress, in
substantial part, considered the ITC and the ACRS to be in pari
materia. See H. Rept. 97-201, at 73-74 (1981); S. Rept. 97-144,
at 47 (1981), 1981-2 C.B. 412, 425; H. Conf. Rept. 97-215, at
206, 213 (1981), 1981-2 C.B. 481, 487, 490. This Court will not
create a distinction unintended by Congress, and, thus, we
conclude that the software loads in issue constitute tangible
property for purposes of the ACRS.
- 26 -
B. Discussion
Taxpayers have long been allowed asset
depreciation deductions in order to allow them to
allocate their expense of using an income-producing
asset to the periods that are benefited by that asset.
* * * an allocation of depreciation to a given year
represents that year’s reduction of the underlying
asset through wear and tear. * * *
Simon v. Commissioner, 103 T.C. 247, 253 (1994), affd. 68 F.3d 41(2d Cir. 1995). Such wear and tear, or “using up”, can be
thought of as being a gradual sale of the capital asset. United
States v. Ludey, 274 U.S. 295, 300-301 (1927). The estimation of
the wear and tear of the capital asset for a given period is
based on the historical cost and does not take into consideration
later fluctuations in valuation through market appreciation.
Fribourg Navigation Co. v. Commissioner, 383 U.S. 272, 277
(1966). Originally, depreciation was calculated by apportioning
the historical cost of the asset, less its salvage value, to the
period the taxpayer expected to use the asset in his business.
Massey Motors, Inc. v. United States, 364 U.S. 92, 107 (1960).
At one time, taxpayers were required to establish the useful
life of the asset, which was the period the taxpayer expected to
use the asset in his trade or business, and which did not
necessarily coincide with the economic life of the asset. Id. at
104; sec. 1.167(a)-1(b), Income Tax Regs. For assets placed in
service after December 31, 1970 (and before 1981), the asset
depreciation range system (ADR) was the primary means of
determining useful lives. Sec. 1.167(a)-11, Income Tax Regs.
- 27 -
The ADR was meant to objectify and standardize the useful lives
of assets by grouping assets into nearly 125 different asset
guideline classes, each with its own guideline period. See sec.
1.167(a)-11(b)(4)(i)(b), Income Tax Regs; Rev. Proc. 77-10, 1977-
1 C.B. 548. Taxpayers had to elect an asset depreciation period
from the ADR assigned to each guideline class, which was 80 to
120 percent of the asset guideline period. Sec. 1.167(a)-
11(b)(4)(i), Income Tax Regs. If no ADR was in effect, or if the
taxpayer did not elect to use the ADR system, the useful life was
determined with reference to the facts and circumstances
surrounding the asset. Simon v. Commissioner, supra.
In 1981, Congress enacted the ACRS by the Economic Recovery
Tax Act of 1981, Pub. L. 97-34, sec. 201, 95 Stat. 203. The ACRS
was meant to stimulate the economy by allowing greater
depreciation by taxpayers through shortened depreciation periods,
as well as simplifying depreciation calculations by reducing the
number of property classes from around 125 under the ADR system
to 5. It was expected that the reduction in the number of
property classes would help alleviate problems associated with
the complexity of the ADR depreciation system. S. Rept. 97-144,
at 47 (1981), 1981-2 C.B. 412, 425. The ACRS is mandatory and
must be used for most depreciable property placed in service
after 1980. Sec. 168(e)(1). Section 168, in relevant part,
provides:
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SEC. 168. ACCELERATED COST RECOVERY SYSTEM.
(a) Allowance of Deduction.--There shall be
allowed as a deduction for any taxable year the amount
determined under this section with respect to recovery
property.
* * * * * * *
(c) Recovery Property.--For purposes of this
title--
(1) Recovery property defined.--* * *
the term “recovery property” means tangible
property of a character subject to the
allowance for depreciation--
(A) used in a trade or
business, or
(B) held for the production of
income.
(2) Classes of recovery property.--Each
item of recovery property shall be assigned
to one of the following classes of property:
* * * * * * *
(B) 5-year property.--The term
“5-year property” means recovery
property which is section 1245
class property and which is not 3-
year property, 10-year property, or
15-year public utility property.
* * * * * * *
(E) 15-year public utility
property.--The term “15-year public
utility property” means public
utility property * * * with a
present class life of more than 25
years.
The parties agree that drop and block is recovery property. To
ascertain which class of property includes the drop and block, it
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is necessary to determine the present class life, defined in
section 168(g)(2):
(g) Definitions.--For purposes of this section--
* * * * * * *
(2) Present class life.--The term
“present class life” means the class life (if
any) which would be applicable with respect
to any property as of January 1, 1981, under
subsection (m) of section 167 (determined
without regard to paragraph (4) thereof and
as if the taxpayer had made an election under
such subsection).
Section 167(m), as it applies to section 168(g)(2), provides
that the Secretary shall prescribe the class lives for each class
of property, which will reasonably reflect the anticipated useful
life of the property class to the industry or group. Sec.
167(m)(1). The Commissioner issued numerous revenue procedures,
pursuant to section 167(m), prescribing or modifying class lives.
See Rev. Proc. 77-10, 1977-1 C.B. 548; Rev. Proc. 72-10, 1972-1
C.B. 721. As of January 1, 1981, the following pertinent asset
guideline classes in Rev. Proc. 77-10, supra, were in effect:
Asset Depreciation Range
(in Years)
Asset
Asset Guide- Lower Guideline Upper
line Class Description of Assets Included Limit Period Limit
48.13 Telephone Station Equipment:
Includes such station apparatus and connections as
teletypewriters, telephones, booths, private exchanges,
and comparable equipment as defined in Federal
Communications Commission Part 31 Account Nos.
231, 232, and 234 . . . . . . . . . . . . . . . . . . . . . 8 10 12
48.14 Telephone Distribution Plant:
- 30 -
Includes such assets as pole lines, cable, aerial wire,
underground conduits and comparable equipment, and
related land improvements as defined in Federal
Communications Commission Part 31 Account Nos. 241,
242.1, 242.2, 242.3, 242.4, 243, and 244 . . . . . . . . . 28 35 42
See also Rev. Proc. 83-35, 1983-1 C.B. 745.3 Under the
regulations promulgated by the FCC for class A and class B
telephone companies,4 as of January 1, 1981, FCC account No. 232
included the original cost of drop and block wires. 47 C.F.R.
sec. 31.232 (1980). Pursuant to Rev. Proc. 77-10, supra, FCC
account No. 232 has an asset guideline period of 10 years, making
it 5-year property under section 168(c)(2)(B), while property in
FCC account No. 242 has an asset guideline period of 35 years,
making it 15-year public utility property under section
168(c)(2)(E). The parties agree that prior to 1984, drop and
block was properly included in FCC account No. 232 and, thus, was
5-year property. In 1984, the FCC regulations were amended so
3
Rev. Proc. 83-35, 1983-1 C.B. 745, was meant to replace,
with certain modifications, preceding revenue procedures,
including Rev. Proc. 77-10, 1977-1 C.B. 548, that prescribed
asset guideline classes, asset guideline depreciation periods,
and ranges for the class life asset depreciation range system.
This revenue procedure leaves intact the assets included and the
depreciation range for asset guideline classes 48.13 and 48.14.
4
Companies having annual operating revenues exceeding
$250,000 are class A telephone companies; Sprint is a class A
company.
- 31 -
that drop and block was included in FCC account No. 242.5 47
C.F.R. secs. 31.242:1, 3 (1984).
Respondent argues that drop and block was FCC account No.
242 property when it was placed in service in 1984 and 1985, and
that FCC account No. 242 property, on January 1, 1981, was
15-year public utility property. Respondent contends that she is
still using the class lives that were in place on January 1,
1981; the FCC, by changing the accounting treatment of drop and
block, has caused the property to be classified as 15-year
property for the years after January 1, 1984. Respondent also
cites various reports of the FCC which tend to support its
accounting change.
Petitioner argues that the plain language of section
168(g)(2) requires that we apply to the property the class lives
that were in effect as of January 1, 1981, thus making drop and
block 5-year property. Finally, petitioner argues that Congress
has twice amended section 168(g)(2), and those amendments should
be read as requiring specific authorization from Congress for any
departure from the January 1, 1981, class lives.
Public utilities, whose rates are often mandated by
expenses, are routinely required to utilize uniform systems of
accounting promulgated by regulatory agencies. See Pacific
5
Drop and block is actually segregated into Federal
Communications Commission (FCC) account No. 242.1, aerial cable,
or 242.3, buried cable. For our purposes, because both accounts
are treated in the same fashion, we need not make the distinction
and will refer simply to FCC account No. 242.
- 32 -
Enters. & Subs. v. Commissioner, 101 T.C. 1 (1993) (gas company);
Kansas City S. Indus., Inc. v. Commissioner, 98 T.C. 242 (1992)
(railroad); Oglethorpe Power Corp. v. Commissioner, T.C. Memo.
1990-505 (electric company); American Tel. & Tel. Co. v.
Commissioner, T.C. Memo. 1988-35 (telephone company). For
Federal tax purposes, if the generally accepted method of
accounting of a taxpayer is made compulsory by a regulatory
agency, and the method clearly reflects income, it is virtually
presumed to be valid for Federal tax purposes. Commissioner v.
Idaho Power Co., 418 U.S. 1, 15 (1974). The FCC accounted for
drop and block in account No. 232 until 1984, when it was
accounted for in account No. 242.1 or 242.3. Respondent looks to
the administrative justifications for such changes. Although
there may have been legitimate and persuasive reasons for the
administrative change in accounting by the FCC, as well as some
industry support, we do not need to reach that issue. It is not
for us today to decide whether the action of the FCC was valid,
justified, or authorized.
Instead the analysis begins with the plain meaning of the
statute, and for reasons which follow, ends there. Respondent
contends that the class lives have never changed; that is,
account No. 242 has always been 15-year public utility property.
That is only one-half of the analysis, for we must also apply
those class lives to property as they would have been applied on
January 1, 1981. The statute, in relevant part, provides that
“``present class life’ means the class life (if any) which would
- 33 -
be applicable with respect to any property as of January 1,
1981”. Sec. 168(g)(2) (emphasis added). We agree with
petitioner; the language is not ambiguous, and accordingly we
need not peer into the legislative history. Nevertheless, such
an inquiry would support our analysis. The intent of the ACRS
was to eliminate disagreement between taxpayers and the
Commissioner and to stimulate economic activity. One essential
theme of the ACRS was predictable depreciation periods; that was
accomplished by freezing in time the property classifications as
they were on January 1, 1981. Until further amendment by
Congress, there were to be no changes.
C. Conclusion
Drop and block, as of January 1, 1981, was included in FCC
account No. 232. That account had an asset guideline period of
10 years, making it 5-year property under section 168(c)(2)(B).
We conclude that drop and block placed in service in the years in
question is 5-year property for purposes of the ACRS.
Decision will be entered
under Rule 155.
Reviewed by the Court.
SWIFT, PARR, WELLS, RUWE, WHALEN, BEGHE, FOLEY, VASQUEZ, and
GALE, JJ., agree with this majority opinion.
CHIECHI, J., did not participate in the consideration of
this opinion.
COLVIN, J., dissents.
- 34 -
KÖRNER, J., dissenting: The majority, relying on Norwest
Corp. & Subs. v. Commissioner, 108 T.C. ___ (1997), filed this
date, concludes that the computer software in issue is tangible
for purposes of the investment tax credit and for purposes of the
accelerated cost recovery system (ACRS). I disagree with the
conclusion reached in Norwest, and respectfully dissent from its
application to this case.
I. Majority Opinion
The majority holds that based on Norwest, the software is
tangible, and further that Sprint was the owner of the software.
I did not have a vote in Norwest, and therefore was unable to
voice my opposition at the time of its adoption. In Norwest, the
Court offers an expansive analysis that discredits the intrinsic
value test; unfortunately, its analysis of its own test is
nowhere near as thorough. Indeed, one of the faults the Court
found in Ronnen v. Commissioner, 90 T.C. 74 (1988), was that it
lacked "rigorous analysis". Norwest Corp. & Subs. v.
Commissioner, supra at __ (slip op. at 19). One would expect
that the Norwest majority, in light of such murky reasoning as it
perceived in Ronnen, would take the opportunity to clear the air
with a definitive test, or at the very least offer some
compelling reasoning to abandon the established precedent of this
Court. Instead, they summarily conclude, with virtually no
analysis, that the software was tangible. This conclusion is
based on their interpretation of the legislative history of the
investment tax credit that the tangibility requirement should be
- 35 -
construed broadly. Their conclusion may also be based (it is not
clear) on the fact that Norwest did not possess the right to
distribute, sell, lease, or license the software it purchased
(the "copyright rights").
A. Attack on the Intrinsic Value Test
The Norwest majority attacks this Court's implicit
conclusion in Ronnen that computer programs were different from
the seismic data at issue in Texas Instruments, Inc. v. United
States, 551 F.2d 599 (5th Cir. 1977), and that the inextricable
connection which existed between the seismic data and tapes in
Texas Instruments was not present between the software and disks
in Ronnen. Norwest Corp. v. Commissioner, supra at __ (slip op.
at 20). I disagree with the Court's conclusion that there is no
fundamental difference between seismic data and a computer
program.
The distinction made in Ronnen v. Commissioner, supra, was
appropriate and warranted by the facts. The seismic data
consisted of the recording of a natural phenomenon. Although a
recording of a natural phenomenon is the result of human
exertion, it is neither the expression of an idea nor an un-
obvious improvement of prior technology or art. Accordingly,
copyright or patent protection is not available for it.1
Software, which is the result of human creativity (not mere
1
Although a recording of music is a recording of a natural
phenomenon which can be copyrighted, it is the creative element
that is copyrightable. See infra.
- 36 -
exertion), can exist as source code on tapes, disks, computer
memory, or written out on paper. As the result of human
creativity and design, copyright or patent protection2 is
available for it. I would therefore conclude that there exists a
material difference between the sound recordings in Texas
Instruments and the computer software purchased by Sprint, and at
issue in Ronnen, and Norwest.
B. Majority's "Traditional Approach"
The Norwest result is based upon an interpretation of the
legislative history of the ITC that the term "tangible" should be
construed broadly and possibly in the absence of copyright
rights. I agree with Judge Jacobs and the other dissenters in
Norwest that the majority's reading of the legislative history is
inappropriate for the reasons stated therein. No purpose would
be served to repeat those arguments. There is, however, an
additional factor in Sprint not present in Norwest. Section 168
requires that property must be tangible to qualify for ACRS
treatment. The majority points out that the ITC and ACRS were
considered by Congress to be in pari materia, and therefore they
extend their expansive construction of "tangible" property to
ACRS. Because I disagree that the legislative history requires
2
Traditionally, software, which is fundamentally a written set
of instructions, was protected under copyright law, and
infringement actions first were brought under copyright law.
Later came a trend to allow patent protection for the design
portion of computer applications. Petry, Taxation of
Intellectual Property, secs. 1.08, 3.04 (1980).
- 37 -
such a broad construction for purposes of the ITC, I similarly
disagree with its extension to ACRS.
1. Absence of Intellectual Property Rights
The second basis of the Norwest majority's holding is that
no copyright rights were passed to Norwest (or Sprint). In
Norwest the Court failed to offer any analysis or cite any cases
which indicate why the presence or absence of such rights should
control the character of the tangible medium which, as the
majority itself points out, is distinct and separate property
from the copyright rights. Norwest Corp. v. Commissioner, supra
at __ (slip op. at 27). The notion that copyright rights are
separate and independent from a tangible embodiment is well
supported. In Rev. Rul. 80-327, 1980-2 C.B. 23, the rights to
manufacture and distribute books were acquired with the plates
used in the printing of the books. The Service analyzed the two
types of property separately and ruled that the plates were
tangible, while the distribution rights were intangible. There
simply is no rational basis to conclude that the presence or
absence of one separate and distinct property interest, the
intangible copyright right, should control the character of other
separate and independent property.
Furthermore, this approach ignores the fact that the
computer source code, which is intellectual property, is property
separate and distinct from the copyright rights and the tangible
medium. As the Court of Appeals for the Sixth Circuit indicated
in Comshare, Inc. v. United States, 27 F.3d 1142, 1145 (6th Cir.
- 38 -
1994), computer software can consist of three types of property:
The tangible computer tapes and disks, the intangible source code
found on the disks, and the intangible copyright rights. Each of
these types of property must be analyzed separately, unless there
is some compelling reason to analyze them together. A computer
program, which may be the creative expression of an idea, or an
unobvious improvement on existing technology or art, can be
protected by copyright and/or patent. Part of this property is
the copyright rights. This intellectual property can exist in
multiple forms, such as on disk, tape, computer memory, or
written out on paper. An analysis must take place when a program
is purchased as to what exactly was purchased. The components
must be identified, and it must be determined whether there is
any compelling reason to consider one or more of the components
together.
The fallacy of the Norwest approach, and the majority here,
is illustrated by considering that if the same property had been
transferred to Norwest (or Sprint), coupled with a copyright
right, then the property would become intangible. Further,
consider that if software was purchased in one year, and the next
year the right to reproduce and sell was acquired, where the
controlling factor for character determination is the presence of
that right, then the property would be tangible in year 1 and
intangible in year 2, despite the fact that it was the same
property.
- 39 -
2. Majority Opinion in Conflict With Case Law
The majority's reliance on the presence or absence of one or
more intangible intellectual property rights to control character
is in direct conflict with the case law. In Comshare, Inc. v.
United States, supra, the taxpayer received (by purchase) the
right to distribute the software. Despite the presence of this
intangible property right, the court went on to conclude that the
software was tangible. Thus, Norwest is in direct conflict with
Comshare. The application of the rationale in Norwest to this
case likewise brings this case in conflict with Comshare.
II. Conservative Approach
Rather than dispose of a hazy test which this Court adopted
in Ronnen v. Commissioner, 90 T.C. 74 (1988), for another one
which is just as hazy and not supported by any case law, I think
we should clarify the test in Ronnen and attempt to distinguish
Comshare, Inc. v. United States, supra. To do so would leave
intact our own precedent, as well as its progeny that relied upon
it.
A. Identify the Subject Property
The first step in applying the intrinsic value test is to
identify the subject property, or in other words, determine what
exactly the taxpayer has purchased or created. In Texas
Instruments, Inc. v. United States, 551 F.2d 599 (5th Cir. 1977),
the court found that seismic data did not exist without the tapes
upon which the data was stored, and accordingly that the data and
- 40 -
tapes were inextricably connected. The intangible information
could not exist without the tangible medium. See Bank of Vermont
v. United States, 61 AFTR 2d 88-788, at 88-790, 88-1 USTC par.
9169, at 83,250 (D. Vt. 1988). Thus, the subject property was
the tape that contained the seismic data. In Comshare, the court
found that the source code was the subject property, but like the
seismic data in Texas Instruments, that it could not exist
without the disks upon which it was stored. Thus, there the
subject property was the unit consisting of the tapes and disks
which contained the source code. In Ronnen v. Commissioner,
supra, the subject property was the source code. We did not find
the same "inextricable connection" that existed between the
seismic data and tapes in Texas Instruments. We instead found
that the disks containing the source code were but one type of
conduit for the ideas contained on it. In Rev. Rul. 80-327,
supra, plates to print books were purchased with the copyright
rights to reproduce and sell copies of the books. The physical
plates containing the creative work product were the subject
property (while the copyright rights were analyzed separately).
In this case, the subject property is the source code.
Sprint paid a fixed amount for the right to one working copy of
that software. There was not simply one embodiment of the
software (as was the case in Comshare). Rather, the intellectual
property existed in more than one locale, and Sprint purchased
the right to use, or possess, a working copy of that intellectual
- 41 -
property. Sprint possessed two copies, while the manufacturer
possessed one. The record indicates that if Sprint had lost one
of its copies, or if one had been destroyed, it would have been
provided with another by the manufacturer. The copies were
interchangeable. There was no significance as to which copy it
used, where it existed, or in what form it existed. Sprint
purchased the right to use the intellectual property of the
manufacturer. The nexus between the intangible information and
the tangible medium is far more attenuated here than in Texas
Instruments, and like the software in Ronnen, is independent of
the tapes upon which it was received. See Bank of Vermont v.
United States, supra.
B. Characterize Property
Once the subject property is identified, it must be
characterized. This is a facts and circumstances analysis, the
focus of which is upon the relationship between the intangible
intellectual property and any tangible medium upon which it
exists. In Texas Instruments, the subject property, consisting
of the intangible information (seismic data) and the tapes, was
permanently embodied and inextricably bound. Therefore, the
property was tangible. Although in Texas Instruments, the
subject property was not software, we nevertheless borrowed the
analysis and applied it to software in Ronnen. Although our
- 42 -
analysis was less than thorough,3 we concluded that "the
intrinsic value of the [subject] software is attributable to its
intangible elements rather than to its tangible embodiments."
Ronnen v. Commissioner, supra. Although this phrase is somewhat
ambiguous, because it appears immediately after the Texas
Instruments analysis, I would interpret it to mean that in
Ronnen, the integral connection between the intangible and
tangible present in Texas Instruments did not exist between the
software and the physical medium. The taxpayer's investment was
not in an intangible which was inextricably bound to the specific
tangible medium upon which it existed, but rather was in the
intangible alone.
Turning to the software purchased by Sprint, an examination
of what Sprint purchased, the right to a copy of source code that
would operate its switches, leads to the conclusion that the
property right is intangible.
II. Conclusion
Based on the foregoing, I cannot agree with the majority
that software is tangible. Therefore, the software is not
eligible for the ITC or ACRS treatment. I believe the following
analysis regarding depreciation of the software, in light of its
3
This discussion illustrates the hazards of adopting a standard
that is less than clear. I cannot adequately emphasize how
improper it would be to abandon our own precedent on the grounds
that it is not fully developed only to replace it by an analysis
that is equally undeveloped.
- 43 -
intangible character, is appropriate. Petitioner contends that
its costs should be amortized over a period no shorter than 60
months pursuant to section 4.01(2) of Rev. Proc. 69-21, 1969-2,
C.B. 303. Respondent contends that the software should be
depreciated over 18 years, the asset guideline period for central
office equipment (COE), for the software was an integral part of
the COE.
Rev. Proc. 69-21, supra, provides in section 4.01:
(.01) With respect to costs of purchased software, the
Service will not disturb the taxpayer's treatment of such
costs if the following practices are consistently followed:
* * * * * * *
2. Where such costs are separately stated, and
the software is treated by the taxpayer as an
intangible asset the cost of which is to be recovered
by amortization deductions ratably over a period of
five years or such shorter period as can be established
by the taxpayer as appropriate in any particular case
if the useful life of the software in his hands will be
less than five years.
Under this revenue procedure, if the taxpayer uses a period
shorter than 5 years, he must establish that the useful life is
less than 5 years; otherwise, the Commissioner will let stand the
amortization period.
The software was separately stated on petitioner's books and
in its purchase invoices from the assets from which it was
purchased. The only issue is whether petitioner treated the
software as an intangible asset. Petitioner did not originally
amortize the software pursuant to this revenue procedure but
rather treated the software and COE as one whole asset and
- 44 -
depreciated that whole asset pursuant to ACRS. Sec.
168(c)(2)(B); Rev. Proc. 83-35, 1983-1 C.B. 745, 758. Petitioner
amortized all other software as an intangible and amortized it
pursuant to Rev. Proc. 69-21, supra, over a 5-year period.
Respondent argues that petitioner did not treat the software
as an intangible and amortize it on its income tax returns for
the years in issue, and that petitioner has not shown that a 5-
year amortization period is appropriate. Petitioner does not
need to show that a 5-year period is appropriate, for it did not
claim an amortization period less than 5 years.4
Respondent looks to the treatment of the COE into which the
software went. COE's belong to asset guideline class 48.12,
which has an asset guideline period of 18 years for purposes of
the class life asset depreciation range system. Rev. Proc. 83-
35, 1983-1 C.B. 745. Under section 168(c)(2)(B), such property
is treated as 5-year property and depreciated over 5 years.
However, as we have held, the software is intangible and
therefore does not qualify for ACRS. Accordingly, respondent has
determined that ACRS treatment is not available for the software,
but the software is still part of the COE, and therefore
depreciable over 18 years.
COHEN, CHABOT, JACOBS, GERBER, and LARO, JJ., agree with
this dissent.
4
If I had to decide whether a shorter period was appropriate, I
would take particular notice of the fact that the software loads
were updated as often as every 6 months, but at least every 2
years.