PNC Bancorp, Inc. Successor to First National Pennsylvania Corporation v. Commissioner ( 1998 )

110 T.C. No. 27UNITED STATES TAX COURT
PNC BANCORP, INC., SUCCESSOR TO FIRST NATIONAL
PENNSYLVANIA CORPORATION, ET AL.,1 Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 16002-95, 16003-95, Filed June 8, 1998.
16109-96, 16110-96.
As a result of mergers, P succeeded to the
interests of two banks. During the years in issue, the
banks' primary source of revenue was interest charged
on loans. In the process of making loans, the banks
incurred costs for property reports, credit reports,
appraisals, recording security interests, and salaries
and benefits to bank employees. The lives of the loans
extended beyond the year in which the expenditures were
incurred. For financial accounting purposes, loan
origination expenditures related to completed loans
were capitalized and amortized over the life of the
loans. For Federal tax purposes, these expenditures
were deducted in the year incurred. P argues that,
1
The following cases are consolidated: PNC Bancorp, Inc.,
Transferee of Assets of First National Pennsylvania Corporation,
docket No. 16003-95; PNC Bancorp, Inc., Successor to United
Federal Bancorp, Inc., and Subsidiaries, docket No. 16109-96; and
PNC Bancorp, Inc., Transferee of Assets of United Federal
Bancorp, Inc., and Subsidiaries, docket No. 16110-96.
2
because the expenditures are both recurring and
integral to the business of the banks, they are
currently deductible under sec. 162(a), I.R.C.
Held: The loan origination expenditures were
incurred in the creation of loans. These loans were
separate and distinct assets that generated revenue
over a period beyond the current taxable year. The
expenditures are not currently deductible under sec.
162(a), I.R.C., and must be capitalized under sec.
263(a), I.R.C.
Robert J. Jones, Thomas R. Dwyer, and Anthony J. O'Donnell,
for petitioner.2
John A. Guarnieri, David B. Silber, and Richard H. Gannon,
for respondent.
RUWE, Judge: These consolidated cases involve deficiencies
determined by respondent as follows:
First National Pennsylvania Corp.
docket Nos. 16002-95 and 16003-95
Year Deficiency
1988 $101,785
1990 978
United Federal Bancorp, Inc.
docket Nos. 16109-96 and 16110-96
Year Deficiency
1990 $7,863
1991 10,236
1992 18,885
1993 7,659
2
Brief amicus curiae was filed for the American Bankers
Association.
3
The sole issue for decision is whether loan origination
expenditures were ordinary and necessary business expenses
properly deductible under section 162(a)3 or whether they are
required to be capitalized under section 263.
FINDINGS OF FACT
Some of the facts have been stipulated and are incorporated
herein by this reference.
During the years in issue, First National Pennsylvania Corp.
(FNPC) was a corporation organized under the laws of Pennsylvania
and was the owner of all the stock of the First National Bank of
Pennsylvania (FNBP), East Bay Mortgage Co., and other
corporations which joined with FNPC in the filing of consolidated
Federal corporation income tax returns (Forms 1120) (the FNPC
Group). The Forms 1120 of the FNPC Group for the calendar years
1988, 1989, and 1990 were prepared using the accrual method of
accounting.
During the years 1990 through 1993, United Federal Bancorp,
Inc. (UFB) was a corporation organized under the laws of
Pennsylvania and was the owner of all the stock of the United
Federal Savings Bank (UFSB) and other corporations which joined
with UFB in the filing of Forms 1120 (the UFB Group). The Forms
3
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the taxable years in
issue, and all Rule references are to the Tax Court Rules on
Practice and Procedure.
4
1120 of the UFB Group for the calendar years 1990 through 1994
were prepared using the accrual method of accounting.
At all times material, FNBP and UFSB were Federally
chartered banks that were actively engaged in the banking
business.
Petitioner is a bank holding company organized as a
corporation under the laws of Delaware. Petitioner's principal
place of business was located in Delaware at the time it filed
the petitions in these cases.4 On or about July 23, 1992, FNPC
was merged into petitioner. On or about January 21, 1994, UFB
was merged into petitioner. By virtue of these mergers,
petitioner succeeded by operation of law to the assets and
liabilities of FNPC and UFB. Petitioner is a transferee at law
of assets of FNPC and UFB and as such would be liable under
section 6901 for any deficiencies in Federal income tax
determined to be owing by FNPC and UFB for the years at issue.
The principal businesses of FNBP and UFSB (collectively
referred to as the banks) consisted of accepting demand and time
deposits and using the amounts deposited, together with other
4
The petitions filed in docket Nos. 16002-95 and 16003-95
were filed by petitioner in response to a notice of deficiency
(in the case of docket No. 16002-95) and a notice of liability
(in the case of docket No. 16003-95) sent to petitioner in its
respective capacities as successor in interest to First National
Pennsylvania Corp. (FNPC) and as transferee of assets of FNPC.
The petitions filed in docket Nos. 16109-96 and 16110-96 were
filed by petitioner in response to a notice of deficiency (in the
case of docket No. 16109-96) and a notice of liability (in the
case of docket No. 16110-96) sent to petitioner in its respective
capacities as successor in interest to United Federal Bancorp,
Inc. and Subs. (UFB) and as transferee of assets of UFB.
5
funds, to make loans. These loans included consumer and
commercial term loans and letters of credit, as well as
residential and commercial mortgage loans. The banks also
provided services and products to customers in addition to the
loans. For consumer customers these services and products
included checking accounts, savings accounts, money market
accounts, safe deposit boxes, automated teller machine (ATM)
cards, overdraft insurance, credit protection insurance,
certified checks, wire transfers, and traveler's checks. For
commercial customers these services and products included,
deposit products, treasury management services, investment
services, employee benefit plan services, and commercial night
drop services.
At all times material, loan interest was the largest source
of revenue, and interest on deposits and other borrowings was the
largest expense for each bank. Each bank also derived revenues
and incurred expenses with respect to safe deposit boxes, ATM
cards, late payments on loans, wire transfers, and traveler's
checks.
Branches operated by the banks had what are commonly
referred to as "teller operations" and "platform operations".
The teller operation at a branch consisted of teller windows
staffed by tellers who, among other tasks, accepted deposits,
disbursed cash, and sold cashier's checks, traveler's checks, and
money orders. Tellers referred customers who were interested in
other bank products, such as loan and deposit products, to
6
platform operation employees. The platform operation at a branch
was conducted by customer service representatives, branch
managers and assistant branch managers, each of whom was assigned
a desk on the floor or "platform" of the branch on the customer's
side of the tellers' windows. These platform employees were
generally responsible for assisting customers in applying for
consumer loans, renting safe deposit boxes, obtaining ATM cards,
opening checking accounts, and opening new deposit accounts
(including time deposits such as certificates of deposit). Each
of the banks also had commercial loan officers who were
responsible for the commercial products offered by the respective
institutions, including loan products, cash management and
deposit products, and employee benefit services.
The banks drew their business from their respective
geographic service areas through a combination of walk-in
business, referrals, prior relationships with customers,
advertising, and the direct, active, and personal solicitation of
new and existing customers through telephone calls, letters, and
other means. Tellers and platform employees of the banks were
encouraged to solicit new business, with an emphasis on
encouraging the customer to look to the banks for a wide variety
of financial services and products. Each of the banks offered
financial incentives to certain of its platform employees and
tellers to sell multiple products and services (cross-sell
incentives). The banks conducted training programs for
employees, including classes dealing with lending and the
7
development of skills in selling loans and other products. UFSB
employed a sales training officer who met with UFSB platform
employees monthly to promote the sale of new UFSB products and
services.
Banks generally are able to earn profits only if they
successfully manage their "net interest margin", which is the
difference between interest earned and interest paid. In order
for banks to operate profitably, their net interest margin plus
revenues from fees and other sources must exceed their losses on
loans and investments (i.e., losses from bad debts) plus
operating costs. A bank's ability to operate profitably is in
large part determined by its credit risk management, since loan
losses are one of the largest controllable expenses at a bank.
Many of the activities that are part of a bank's lending function
are related to credit risk management. These activities include
the establishment of written policies and procedures, the loan
application process, credit investigation, credit evaluation,
documentation, collections, and portfolio supervision. A bank
establishes its written policies and procedures with respect to
loans after it has determined the types of loans that it will
offer and the markets that it will target.5 Once the loan
products are identified, the bank develops written policies
5
During the years in issue, the banks offered various kinds
of loans and loan commitments to their existing and prospective
customers at varying rates of interest and for varying periods of
time. Some loans were offered at fixed rates of interest and
others at variable rates of interest.
8
regarding its tolerance for risk, how and under what terms loans
are to be made, pricing and profit objectives, documentation
requirements, acceptable levels of credit losses, and collection
and chargeoff procedures. The risk management process requires
continuous adjustment and refinement to address the competing
interests of marketing loans to as many customers as possible
while at the same time insuring that the bank makes low risk
loans.
Consumer Loans6
Platform employees at the banks typically met with
prospective consumer borrowers to explain available loan products
and to assist the prospective borrowers in completing a loan
application where appropriate. The consumer loan applications
were generally taken by branch employees. The application
identified the prospective borrower and described the prospective
borrower's income and assets, existing debt, the purpose of the
loan, and other data necessary to evaluate the prospective
borrower's financial condition. Where loans were to be secured
by an interest in real property, the application would also
include a description of the collateral sufficient to permit the
ordering of a property report or appraisal.
The application process is the primary means by which banks
obtain information from consumer customers. The banks took a
6
Both the FNPC cases and the UFB cases involve expenditures
relating to consumer loans.
9
loan application for every consumer loan request. At UFSB,
approximately 325 to 350 consumer loan applications were taken in
a typical month of which approximately 200 to 220 were approved.
At the main central branch of FNBP and its two satellite offices,
approximately 90 to 100 consumer loan applications were taken in
a typical month of which approximately 80 to 90 were approved.
Following completion of the application, the banks obtained
a credit report on the prospective borrower. Where a loan was to
be secured by real property, the banks typically obtained a
property report to identify any liens or other encumbrances. If
the result of the property report was satisfactory, an appraisal
of the property was typically obtained.
In evaluating whether to make a consumer loan, the banks
would consider certain financial ratios as well as other criteria
set forth in their established loan policies. The ratios that
were examined included debt to income and, where the loan was to
be secured with collateral, loan to value. In addition to
examination of the various financial ratios, the banks often
looked at a loan applicant's payment history and financial
stability.
Where the consumer loan application was denied, the
responsible platform employee would discuss the reasons for
credit denial with the prospective borrower and encourage the
prospective borrower to apply again in the future. In
10
appropriate instances, the applicant would be offered a smaller
loan or a loan on different terms.7
Applications for consumer loans that were approved were
generally closed in the branch where the loan application was
taken. Closing included, among other things, the prospective
borrower's execution of a note or other evidence of indebtedness,
the prospective borrower's execution of a security agreement or
other document conveying a security interest in collateral where
appropriate, the delivery of those documents to the banks and, on
the part of the banks, some act making the loan proceeds
available or, in the case of a new line of credit, some act
memorializing the banks' agreements to disburse funds on demand.
The banks recorded the documents necessary to perfect a security
interest in collateral where appropriate.
The prospective borrower could decide not to enter into a
loan transaction at any time prior to closing. Similarly, the
banks could decide not to enter into a loan transaction at any
time prior to closing, except where they had entered into a loan
commitment with the prospective borrower. The banks generally
did not charge fees in connection with consumer loans because of
competitive factors.8
7
In some instances, credit was approved in an amount greater
than that sought in the application, and the appropriate platform
employee was encouraged to "upsell" the loan to the prospective
borrower.
8
The term "fees" refers to amounts paid by the borrower in
connection with the loan origination process. The term "costs"
refers to expenses incurred by the banks.
11
Commercial Loans
Respondent disallowed deductions related to the origination
of commercial loans made by FNBP. No adjustments for commercial
loan origination costs were made with respect to UFSB.9
FNBP employees with responsibility for commercial products
and services met with prospective commercial borrowers to explain
the available loan products. Where the prospective borrower
wished to apply for a loan, the responsible employee obtained
information needed to complete a loan application. FNBP employed
as many as nine commercial loan officers to handle its larger
business customers and to develop new commercial business. Some
FNBP branch managers also acted as commercial loan officers.
Commercial loan officers at FNBP typically had 25 to 30 clients
and spent approximately 85 percent of their time dealing with
existing clients and about 15 percent of their time with
prospective clients. FNBP commercial loan officers visited
existing clients on a quarterly basis at which time they
discussed, among other things, the client's financial statements
and overall financial condition.
Commercial loan applications identified the prospective
borrower and described the prospective borrower's income, assets,
and liabilities; the purpose of the loan; and other data
9
There is no explanation for this, and the parties do not
base any of their arguments on this disparity.
12
necessary to evaluate the prospective borrower's financial
condition. Where loans were to be secured by an interest in real
property, the application would include a description of the
collateral sufficient to permit the ordering of a property report
or appraisal. FNBP would generally obtain 3 years of financial
statements, interim financial statements, aging reports to
determine the current status of accounts receivable and payable,
and secured transaction reports to determine whether any liens
had been filed against the property of the client. Applicants
also typically submitted personal financial statements of
guarantors, operating projections, a business plan,
organizational documents, and certificates of good standing and
references. Information obtained in connection with a commercial
loan request was used to evaluate the creditworthiness of the
client and to identify other needs of the client that might be
met by the bank such as investment services, treasury management
services, and employee benefit services.
As a general rule, evaluation of a commercial loan
application required FNBP to obtain more information and to
expend more resources than was required in the case of a consumer
loan application. In a typical month, each of the nine
commercial loan officers at FNBP took between 2 and 10 commercial
loan requests. With respect to commercial loans, it was common
for FNBP and the prospective borrower to negotiate the loan
terms.
13
In evaluating whether to make a commercial loan, FNBP would
consider factors similar to those considered in evaluating
consumer loans. FNBP examined payment capacity, including debt-
to-income ratios, payment history, financial stability, and,
where appropriate, issues relating to collateral including loan-
to-value ratios. Financial stability for commercial borrowers
involves an examination of sales, earnings, and management.
Commercial loans were closed at various locations including
FNBP's offices, the prospective borrower's place of business, or
an attorney's office.10 Closing included, among other things,
the borrower's execution of a note or other evidence of
indebtedness, execution of a document conveying a security
interest in collateral, delivery of those documents to FNBP and,
on the part of FNBP, some act making the loan proceeds available
or, in the case of a new line of credit, some act memorializing
FNBP's agreement to disburse funds on demand. The closing of
some commercial loans was handled by FNBP employees, and others
were handled by outside legal counsel. If the closing were
handled by FNBP employees, closing documents would be prepared
and recorded by those employees. If the closing were handled by
outside counsel, the outside counsel would prepare and record
closing documents. The recording of security interests in
10
When the loan application was denied, the employee dealing
with the prospective commercial borrower would discuss the
reasons for credit denial with the prospective borrower and
encourage the prospective borrower to apply again in the future.
In appropriate instances, the applicant would be offered a
smaller loan or a loan on different terms.
14
connection with commercial loans was an event which occurred
regularly at FNBP.
FNBP charged fees with respect to some commercial real
estate loans but did not charge fees with respect to other
commercial loans because of competitive pressures.
Computation of Respondent's Adjustments
Respondent disallowed deductions for certain costs that the
banks had identified as costs incurred in connection with the
origination of loans. For financial accounting purposes, the
banks had deferred these costs over the expected life of the
subject loans in a manner consistent with the Statement of
Financial Accounting Standards No. 91, "Accounting for
Nonrefundable Fees and Costs Associated with Originating or
Acquiring Loans and Initial Direct Costs of Leases" (SFAS 91).11
SFAS 91 was adopted by the Financial Accounting Standards
Board in 1986, effective for fiscal years beginning after
December 15, 1987.12 Paragraph 5 of SFAS 91 provides that "loan
origination fees", as defined in SFAS 91, must be "deferred and
recognized over the life of the loan as an adjustment of yield
(interest income)", and that "direct loan origination costs", as
defined in paragraph 6 of SFAS 91, must be "deferred and
11
The banks determined the costs at issue to be deferred for
financial reporting purposes in a manner consistent with SFAS 91.
Respondent used these amounts to compute the adjustments, but
does not rely on SFAS 91 in determining whether these costs can
be deducted under sec. 162(a).
12
The relevant text of SFAS 91 is examined infra.
15
recognized as a reduction in the yield of the loan" except for
certain cases involving "troubled debt restructuring". Paragraph
5 of SFAS 91 further provides that "Loan origination fees and
related direct loan origination costs for a given loan shall be
offset and only the net amount shall be deferred and amortized."
FNPC Costs at Issue
FNPC adopted SFAS 91 on a prospective basis effective for
transactions entered into after December 31, 1987. Prior to its
application of SFAS 91, FNPC, in accordance with its established
accounting practices, treated the costs described in SFAS 91 as
current expenses for financial accounting and reporting purposes.
In 1988, FNPC began to defer fees and costs described in SFAS 91
for financial accounting and reporting purposes. For each of the
years in issue and, to the best knowledge of management, for all
prior years, FNBP currently deducted the costs described in SFAS
91 for Federal income tax purposes. To apply SFAS 91, FNPC
established separate ledger accounts in order to record fees and
costs subject to deferral, as well as to reflect the portion of
net deferred fees and costs recognized as an adjustment to
interest yield in accordance with SFAS 91. To comply with SFAS
91, FNPC deferred the net amount of the costs and fees in each of
the ledger accounts and recognized these net amounts as
components of interest income over the estimated lives of the
loans.
16
The FNPC ledger accounts were adjusted at least annually to
reflect the portions of the deferred costs (which costs were
determined pursuant to SFAS 91) and deferred fees that had been
recognized as components of interest income in computing net
income for financial reporting purposes. The FNPC ledger
accounts were titled: Commercial loans--deferred fees/costs;
Installment loans--deferred fees/costs; and Mortgage loans--
deferred fees/costs. The balances in a particular FNPC ledger
account at the end of a given period reflected the cumulative net
amount that had been deferred but had not been recognized for
financial reporting purposes by FNPC as a component of interest
income under SFAS 91. Current balances in the FNPC ledger
accounts did not separately break out the amount of such fees,
costs, and adjustments to yield entered in those accounts. A
change in the balance of an FNPC ledger account from the end of
one year to the end of the next year reflected the net fees and
costs deferred by FNPC in calculating its net income for
financial reporting purposes under SFAS 91.
The Schedules M-1, Reconciliation of Income per Books With
Income per Return, filed with FNPC's Forms 1120 for the periods
in question, reflect that the net costs and fees recorded in the
FNPC ledger accounts were deferred and amortized pursuant to SFAS
91 for financial accounting purposes, and that the net costs and
fees were currently deducted as expenses or reported as income
for Federal income tax purposes.
17
The evidence does not separately identify the allocated
costs that were reflected in the FNPC ledger accounts used by
respondent in calculating the disallowed amounts. However,
because those ledger accounts were established in order to comply
with SFAS 91, the allocated costs reflected in the disallowed
amounts necessarily consisted of some combination of the
following: (1) Costs paid by FNBP to third parties for property
reports, credit reports and appraisals, and costs for recording
security interests, and (2) an allocable portion of the costs
incurred by FNBP for salaries and benefits of its employees (and
related costs) attributable to the following activities:
Evaluating the financial condition of prospective borrowers;
evaluating and recording guaranties, collateral and other
security arrangements; negotiating loan terms; preparing and
processing loan documents; and closing loan transactions. The
costs at issue in the FNPC cases do not include any costs
incurred in connection with unsuccessful loan efforts (i.e.,
where a loan was not originated) or any costs incurred following
a loan's origination by FNBP.
Respondent disallowed FNPC's claimed deductions for loan
origination costs in the amounts of $568,283, $392,321, and
$26,060 in taxable years 1988, 1989, and 1990, respectively.
These adjustments represent amounts (net of amortization or yield
adjustments) that were deferred by FNPC in its ledger accounts to
comply with SFAS 91 for financial accounting and reporting
purposes. The fees and costs included in determining these
18
amounts were included in income and deducted by FNPC for Federal
income tax purposes on a current basis. Because respondent's
adjustments were based on the balances in the FNPC ledger
accounts, those adjustments took into account any amortization or
yield adjustment that was reflected in such accounts.
UFB Costs at Issue
UFB adopted SFAS 91 effective for 1988 on a retroactive
basis for its outstanding residential mortgage loans and on a
prospective basis for its other loans. Prior to its application
of SFAS 91, UFB, in accordance with its established accounting
practices, treated the costs described in SFAS 91 as current
expenses for financial accounting and reporting purposes. In
1988, UFB began to defer fees and costs described in SFAS 91 for
financial accounting and reporting purposes. For each of the
years in issue and, to the best knowledge of management, for all
prior years, UFB currently deducted the costs described in SFAS
91 for Federal income tax purposes. To apply SFAS 91, UFB
established ledger accounts to record fees and costs subject to
deferral with respect to several categories of loans in
accordance with SFAS 91. Unlike the ending balances in the FNPC
ledger accounts, which reflected only net numbers, the UFB ledger
accounts recorded fees and costs separately. In addition, the
amortization or adjustments to yield of amounts deferred under
SFAS 91 by UFB were recorded in separate general ledger accounts.
19
Some of the deferred costs recorded in the UFB ledger
accounts were based on standard cost surveys performed by UFB for
the purpose of complying with SFAS 91. Different standard cost
amounts were determined by UFB for subcategories of loans within
a general category. For example, with respect to consumer loans
originated in 1991 and 1992, different standard cost amounts were
determined for unsecured consumer loans, secured consumer loans
for which UFSB performed an appraisal, and secured consumer loans
for which an outside third party performed an appraisal. Except
with respect to records maintained in connection with its
standard cost surveys, UFB did not maintain time records
reflecting the amount of time UFSB employees spent working on
individual consumer lending transactions. UFB likewise did not
maintain records summarizing actual expenditures for items such
as supplies, telephone calls, credit reports, property reports,
title searches, recording fees and attorney's fees with respect
to individual consumer lending transactions.
The fees and costs recorded in the UFB ledger accounts were
deferred and recognized as a component of interest income over
the estimated expected life (not the contractual life) of the
loans to which they related in accordance with SFAS 91. For
Federal income tax purposes, the amounts recorded in the UFB
ledger accounts were reported by UFB as current items of income
or expense. The Schedules M-1 filed with UFB's Forms 1120 for
the periods in question reflect that the net amount of the costs
and fees recorded in the UFB ledger accounts was deferred and
20
amortized pursuant to SFAS 91 for financial accounting purposes,
and that such costs and fees were currently reported as income or
deducted as expenses for Federal income tax purposes.
Respondent calculated the adjustments in issue in the UFB
cases based solely on the balances in some of the UFB fee and
cost ledger accounts. The fees and costs reflected in those
accounts were included in income and deducted by UFB on its Forms
1120 for the years received or incurred. Respondent reduced the
adjustments so determined by an allowance for amortization, which
was calculated using a half-year convention and was based on an
estimated loan life of 3 years. The amortization deduction
permitted by respondent differs from the amortization taken into
account by UFB as a component of interest income in accordance
with SFAS 91.
The costs at issue in the UFB cases include only costs
incurred by UFSB with respect to the origination of consumer
loans and specifically include only standard costs paid by UFSB
to record security interests and standard costs paid to third
parties for property reports, credit reports, and appraisals.
Respondent made no adjustments with respect to other UFSB loan
categories, such as commercial loans and residential and
commercial mortgage loans. The costs at issue in the UFB cases
do not include any costs incurred in connection with UFSB's
unsuccessful loan efforts (i.e., where a loan was not originated)
or any costs incurred following a loan's origination by UFSB.
The following table reflects the loan origination costs
21
disallowed and the amortization amounts allowed by respondent for
UFSB as well as the increased income determined by respondent as
a result of these adjustments:
Net Loan Amortization Increased
Year Origination Cost1 Amount Income
1990 $30,094 ($5,016) $25,078
1991 60,225 (20,069) 40,156
1992 108,410 (48,175) 60,235
1993 101,955 (78,220) 23,735
1
This is the excess of deferred loan origination costs over
deferred fees.
OPINION
The sole issue for decision is whether certain expenditures
incurred in connection with the origination of loans are
deductible as ordinary and necessary business expenses under
section 162. Respondent determined that they are not deductible
because section 263 requires that they be capitalized.
To qualify as an allowable deduction under section 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 Association, 403 U.S. 345,
352 (1971). Respondent argues that the expenses in question were
not ordinary and, therefore, not currently deductible.
In one sense, the term "ordinary" in section 162 prevents
the deduction of expenses that are not normally incurred in the
type of business in which the taxpayer is engaged ("ordinary" in
22
the sense of "normal, usual, or customary" in a taxpayer's trade
or business). Deputy v. du Pont, 308 U.S. 488, 495 (1940). More
importantly, the term "ordinary" serves as a means to "clarify
the distinction, often difficult, between those expenses that are
currently deductible and those that are in the nature of capital
expenditures, which, if deductible at all, must be amortized over
the useful life of the asset." Commissioner v. Tellier, 383 U.S.
687, 689-690 (1966).
No current deduction is allowed for a capital expenditure.
Sec. 263(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 83
(1992). Section 1.263(a)-2(a), Income Tax Regs., includes as
examples of capital expenditures "The cost of acquisition,
construction, or erection of buildings, machinery and equipment,
furniture and fixtures, and similar property having a useful life
substantially beyond the taxable year." Section 461(a) provides
that "The amount of any deduction * * * shall be taken for the
taxable year which is the proper taxable year under the method of
accounting used in computing taxable income." Section 1.461-
1(a)(2), Income Tax Regs., provides further guidance as to when a
capital expenditure should be taken into account for Federal
income tax purposes under an accrual method of accounting:
any expenditure which results in the creation of an
asset having a useful life which extends substantially
beyond the close of the taxable year may not be
deductible, or may be deductible only in part, for the
taxable year in which incurred. * * *[13]
13
Sec. 1.461-1, Income Tax Regs., was amended by T.D. 8408,
(continued...)
23
The Supreme Court in INDOPCO, Inc. v. Commissioner, supra at
83-84, stated:
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
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. * * * 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. * * *
Income tax deductions are a matter of legislative grace and
the burden of clearly showing the right to the claimed deduction
is on the taxpayer. INDOPCO, Inc. v. Commissioner, supra at 84.
Moreover, deductions are strictly construed and allowed only "'as
there is clear provision therefor.'" Id. (quoting New Colonial
Ice Co. v. Helvering, 292 U.S. 435, 440 (1934)).
In light of these general principles, we now turn to the
facts of these cases. All the costs at issue were incurred by
13
(...continued)
1992-1 C.B. 155, 165. The relevant changes were effective Apr.
10, 1992, and provide:
under section 263 or 263A, a liability that relates to
the creation of an asset having a useful life extending
substantially beyond the close of the taxable year is
taken into account in the taxable year incurred through
capitalization * * * and may later affect the
computation of taxable income through depreciation or
otherwise over a period including subsequent taxable
years, in accordance with applicable Code sections and
guidance published by the Secretary. * * *
24
the banks to create new loans.14 The costs, which the banks
identified as loan origination costs in their books and records,
were deferred by the banks for financial accounting purposes in
accordance with SFAS 91 and were currently deducted by them for
Federal income tax purposes.15 The costs at issue include
amounts paid to record security interests and amounts paid to
third parties for property reports, credit reports, and
appraisals. In the case of FNBP, the costs at issue also include
an allocable portion of the salaries and fringe benefits paid to
employees for evaluating the borrower's financial condition,
evaluating guaranties, collateral and other security
arrangements, negotiating loan terms, preparing and processing
loan documents, and closing the loan transaction.
Respondent contends that the loans constitute separate and
distinct assets of the banks. In Commissioner v. Lincoln Sav. &
Loan Association, supra at 354, the Supreme Court held that the
payments in that case served:
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
14
While the evidence does not specifically identify the
lives of the loans in question, petitioner makes no argument that
the lives of such loans did not extend substantially beyond the
taxable years in which the loans were originated.
15
The provisions of SFAS 91 do not control the proper
characterization of the costs at issue. Thor Power Tool Co. v.
Commissioner, 439 U.S. 522, 542-543 (1979); Old Colony R.R. Co.
v. Commissioner, 284 U.S. 552, 562 (1932) (holding that
compulsory accounting rules do not control tax consequences).
25
expense, deductible under § 162(a) in the absence of
other factors not established here. * * *
In INDOPCO, Inc. v. Commissioner, supra at 86, the Supreme Court
explained that "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 §
263."
Petitioner does not argue that the loans are not separate
and distinct assets of the banks. Clearly they are. Rather,
petitioner argues that there are "other factors" present which
allow deductibility of the loan origination costs. The factors
upon which petitioner relies are that the type of costs in issue
are incurred every day in the banking business, they are integral
to the day-to-day banking operations of the banks, and they
provide only short-term benefits. Petitioner concludes that the
"every-day, recurring costs" at issue are currently deductible
under section 162(a).
Recurring Expenses
Relying on Iowa-Des Moines Natl. Bank v. Commissioner, 68
T.C. 872 (1977), affd. 592 F.2d 433 (8th Cir. 1979); Colorado
Springs Natl. Bank v. United States, 505 F.2d 1185 (10th Cir.
1974); and First Natl. Bank of South Carolina v. United States,
558 F.2d 721 (4th Cir. 1977), petitioner asserts that credit
evaluation and recordkeeping costs, such as those at issue here,
are currently deductible and not required to be capitalized under
26
section 263(a).16 These cases addressed the deductibility of
costs incurred by taxpayers to expand their banking businesses by
issuing credit cards. The costs deducted by the taxpayers in
these cases included payments to "agent banks" for services
performed in screening the credit history of prospective credit
cardholders, payments to third parties for the collection of
credit data, payments to a clearinghouse for entering credit card
data on the taxpayer's behalf, and salaries paid to employees in
connection with starting up the taxpayer's credit card system,
including costs to perform credit evaluations of prospective
cardholders.
Petitioner focuses on the similarity of the type of expenses
in the instant cases. However, the holdings in the cases upon
which petitioner relies were not simply based on the "everyday,
recurring nature" of the costs at issue. Rather, the critical
factor for allowing the current deduction of certain of the
expenses in those cases was that the costs "for advertising and
promotional aids, salaries, data processing, and credit bureau
searches were merely related to the active conduct of an existing
business and did not create or enhance a separate and distinct
asset or property interest." Iowa-Des Moines Natl. Bank v.
Commissioner, supra at 879 (emphasis added). Similarly, in
Colorado Springs Natl. Bank v. United States, supra at 1192, the
Court of Appeals for the Tenth Circuit noted that "The start-up
16
Petitioner also cites First Sec. Bank of Idaho N.A. v.
Commissioner, 63 T.C. 644 (1975), affd. 592 F.2d 1050 (9th Cir.
1979), in support of its assertion.
27
expenditures here challenged did not create a property interest.
They produced nothing corporeal or salable." See also First
Natl. Bank of South Carolina v. United States, supra at 723
("Membership in ASBA is not a separate and distinct additional
asset created or enhanced by the payments in question.").
The cases cited by petitioner are distinguishable from the
facts before us because the expenses in the instant cases created
loans which were separate and distinct assets. Although
petitioner may be correct that loan origination expenses are
"similar" to those incurred in the cases on which it relies,
nonetheless, in the instant cases separate and distinct assets
were created. Thus, the cited cases do not support petitioner's
argument and certainly are not "direct precedent" as it contends.
See Ellis Banking Corp. v. Commissioner, T.C. Memo. 1981-123,
affd. in part and remanded in part on another issue 688 F.2d 1376(11th Cir. 1982) (distinguishing cases the taxpayer relied upon
by the fact that separate and distinct assets were not acquired).
The facts and circumstances of each case must be examined to
determine whether an expense should be capitalized or currently
deducted. See INDOPCO, Inc. v. Commissioner, 503 U.S. at 86;
Deputy v. du Pont, 308 U.S. at 496; United States v. General
Bancshares Corp., 388 F.2d 184, 187-188 (8th Cir. 1968)
(expenditures must be viewed "in context with the transaction in
which they are incurred to assess their proper
characterization."). A particular cost, no matter what its type,
may be deductible in one context but may be required to be
28
capitalized in another context. For example, in Commissioner v.
Idaho Power Co., 418 U.S. 1, 13 (1974), the Supreme Court noted
the following regarding wages paid by a taxpayer in its trade or
business:
Of course, reasonable wages paid in the carrying on of
a trade or business qualify as a deduction from gross
income. * * * But when wages are paid in connection
with the construction or acquisition of a capital
asset, they must be capitalized and are then entitled
to be amortized over the life of the capital asset so
acquired.[17]
Simply because other cases have allowed a current deduction for
similar expenses in different contexts does not require the same
result here. Expenditures, which otherwise might qualify as
currently deductible must be capitalized if they are incurred in
the acquisition of a separate and distinct asset regardless of
their recurring nature. "[A]n expenditure that would ordinarily
be a deductible expense must nonetheless be capitalized if it is
incurred in connection with the acquisition of a capital asset."
Ellis Banking Corp. v. Commissioner, 688 F.2d at 1379.
In Commissioner v. Idaho Power Co., supra at 16, the Supreme
Court considered the interrelationship between Part VI (which
includes section 161 and following, relating to items deductible)
17
"It is clear that an expenditure need not be for a capital
asset, as described in Section 1221 * * * in order to be
classified as a capital expenditure." Georator Corp. v. United
States, 485 F.2d 283, 285 (4th Cir. 1973); see also NCNB Corp. v.
United States, 684 F.2d 285, 290 n.7 (4th Cir. 1982) (recognizing
that, although sec. 1221 defines capital asset, "it does so for
the purpose of determining capital gains and losses and not for
determining what expenditures are capital.").
29
and Part IX (which includes section 261 and following, relating
to items not deductible) of the Internal Revenue Code. The Court
held that the priority-ordering directives of sections 161 and
261 require that the capitalization provision of section 263(a)
take precedence over section 162(a). Commissioner v. Idaho Power
Co., supra at 17. Section 161 provides that "In computing
taxable income under section 63, there shall be allowed as
deductions the items specified in this part, subject to the
exceptions provided in part IX". As the Supreme Court explained:
The clear import of § 161 is that, with stated
exceptions set forth either in § 263 itself or provided
for elsewhere (as, for example, in § 404 relating to
pension contributions), none of which is applicable
here, an expenditure incurred in acquiring capital
assets must be capitalized even when the expenditure
otherwise might be deemed deductible under Part VI.
[Commissioner v. Idaho Power Co., supra at 17; emphasis
added.]
And, as the Supreme Court more recently observed:
The notion that deductions are exceptions to the norm
of capitalization finds support in various aspects of
the Code. Deductions are specifically enumerated and
thus are subject to disallowance in favor of
capitalization. See §§ 161 and 261. Nondeductible
capital expenditures, by contrast, are not exhaustively
enumerated in the Code; rather than providing a
"complete list of nondeductible expenditures," Lincoln
Savings, 403 U.S., at 358, * * * § 263 serves as a
general means of distinguishing capital expenditures
from current expenses. See Commissioner v. Idaho Power
Co., 418 U.S., at 16. * * * For these reasons,
deductions are strictly construed and allowed only "as
there is a clear provision therefor." [INDOPCO, Inc.
v. Commissioner, 503 U.S. at 84.]
30
Petitioner failed to cite, nor do we find, any authority
which stands for the proposition that expenses incurred in the
creation of separate and distinct assets are currently deductible
if such expenses are incurred regularly. Accordingly, the fact
that the banks incurred expenditures on a recurring basis does
not ensure their characterization as "ordinary" if they are
incurred in the creation of a separate and distinct asset. See
Helvering v. Winmill, 305 U.S. 79, 84 (1938) (denying deduction
for commissions even though they were regular and recurring
expenses in the taxpayer's business of buying and selling
securities).
Integral Part of Business
Petitioner contends that another important factor in
determining whether the particular expenditures should be
capitalized or currently deducted is that they are integrally
related to the conduct of the banks' business. Petitioner argues
that this factor addresses the pragmatic concern that, in some
businesses, almost all costs theoretically could be allocated in
some fashion to the acquisition of assets, so that under an
overly expansive view of section 263, the availability of section
162 deductions for such businesses would be largely eliminated.
We have examined the cases and revenue rulings cited by
petitioner in support of this argument and do not find them
controlling, nor do we find that they support the proposition for
which petitioner contends.
31
Furthermore, petitioner's fear of an "overly expansive"
application of section 263 is not warranted here. It is clear
that the expenses at issue are directly related to the creation
of the loans. Petitioner provides little, if any, explanation
regarding the method the banks employed in identifying the
expenses associated with the origination of the loans. However,
because the parties stipulated that the banks deferred the
expenses at issue for financial accounting purposes in a manner
consistent with SFAS 91, we turn to the definitions contained
therein for such explanation.18
Generally, paragraph 5 of SFAS 91 requires that direct loan
origination costs "shall be deferred and recognized as a
reduction in the yield of the loan".19 Paragraphs 6 and 7 of
SFAS 91 define what type of costs must be deferred and those
which are currently expensed:
6. Direct loan origination costs of a completed loan
shall include only (a) incremental direct costs of loan
origination incurred in transactions with independent
third parties for that loan and (b) certain costs
directly related to specified activities performed by
the lender for that loan. Those activities are:
evaluating the prospective borrower's financial
18
We reiterate that SFAS 91 does not control the correct
characterization of the subject expenses. We merely examine the
statement to define the nature of the costs at issue and how they
relate to the asset created. Furthermore, we note that
petitioner does not argue that the direct costs of the loans, as
reflected in the banks' financial accounting records, were
inaccurately or improperly allocated.
19
Paragraph 5 of SFAS 91 also requires that "Loan
origination fees and related direct loan origination costs for a
given loan shall be offset and only the net amount shall be
deferred and amortized."
32
condition; evaluating and recording guarantees,
collateral, and other security arrangements;
negotiating loan terms; preparing and processing loan
documents; and closing the transaction. The costs
directly related to those activities shall include only
that portion of the employees' total compensation and
payroll-related fringe benefits directly related to
time spent performing those activities for that loan
and other costs related to those activities that would
not have been incurred but for that loan.
7. All other lending-related costs, including costs
related to activities performed by the lender for
advertising, soliciting potential borrowers, servicing
existing loans, and other ancillary activities related
to establishing and monitoring credit policies,
supervision, and administration, shall be charged to
expense as incurred. Employees' compensation and
fringe benefits related to those activities,
unsuccessful loan origination efforts, and idle time
shall be charged to expense as incurred.
Administrative costs, rent, depreciation, and all other
occupancy and equipment costs are considered indirect
costs and shall be charged to expense as incurred.[20]
It is clear that the costs at issue are only those directly
related to the creation of the loans. They do not include costs
associated with loans that were not completed, nor do they
include costs incurred after the closing of a loan.
Short-term Benefit of Expenses
Petitioner presented the testimony of several witnesses at
trial in an attempt to prove that the value of credit reports and
20
Appendix C to SFAS 91 defines the term "incremental direct
costs" to mean "Costs to originate a loan that (a) result
directly from and are essential to the lending transaction and
(b) would not have been incurred by the lender had that lending
transaction not occurred."
33
similar financial data lasts only a short period of time.21 We
do not find this evidence determinative of the issue before us.22
A bank obtains loan applications, credit reports and similar
data to evaluate a potential borrower's financial condition for
purposes of determining whether to make a loan. When funds are
disbursed and a loan is created, the loan becomes a separate and
distinct bank asset. Under the reasoning of Commissioner v.
Lincoln Sav. & Loan Association, 403 U.S. at 354, costs that
serve to create a loan, such as costs of credit reports and
financial evaluations, are costs that must be capitalized and
amortized over the useful lives of those loans. "The requirement
that costs be capitalized extends beyond the price payable to the
seller to include any costs incurred by the buyer in connection
with the purchase, such as appraisals of the property or the
costs of meeting any conditions of the sale." Ellis Banking
Corp. v. Commissioner, 688 F.2d 1376, 1379 (11th Cir. 1982); see
also Woodward v. Commissioner, 397 U.S. 572 (1970) (ancillary
expenses, such as legal, accounting, and appraisal costs,
21
We note that some of the expenditures in issue were
incurred in connection with the preparation and recording of
notes and security interests. The rights created and secured by
these expenditures clearly remain in effect for the life of the
loan. The record does not contain a breakdown showing the
amounts of the various types of expenditures.
22
Although the short useful life of credit information was a
factor considered by the court in Iowa-Des Moines Natl. Bank v.
Commissioner, 592 F.2d 433 (8th Cir. 1979), affg. 68 T.C. 872(1977), we found that the expenditures at issue in that case did
not create or enhance a separate and distinct asset or property
interest. Therefore, Iowa-Des Moines Natl. Bank v. Commissioner,
supra, is distinguishable.
34
incurred in acquiring an asset are capital expenditures); United
States v. Hilton Hotels Corp., 397 U.S. 580 (1970) (fees paid to
a consulting firm and the cost of legal and other professional
services incurred in connection with appraisal proceeding to
value shares of dissenting shareholders in merged corporation
were capital expenditures).
Credit reports, appraisals, and similar information about
prospective borrowers are critical in deciding whether to make a
loan. It is the basis on which banks make their credit risk
management decisions. While the specific information available
when a loan is made may become outdated in a relatively short
period of time, the quality of the decision to make a loan (and
thereby acquire an asset) is predicated on such information. The
soundness of the decision to make a loan is assimilated into the
quality and value of the loan. Thus, the direct costs of the
decision-making process should be assimilated into the asset that
was acquired. See Commissioner v. Idaho Power Co., 418 U.S. at
14 (held that construction-related depreciation cannot be
currently deducted "rather, the investment in the equipment is
assimilated into the cost of the capital asset constructed.")
In Strouth v. Commissioner, T.C. Memo. 1987-552, the
taxpayers were partners in several partnerships engaged in the
business of purchasing and leasing office equipment to local
companies and professional offices. Generally, the terms of
these leases ranged from 3 to 5 years. The partnerships paid a
corporation to perform services associated with the leasing
35
activity, which included, among other things, securing potential
leases, reviewing the lessee's application, checking the lessee's
credit and trade references, and drafting lease documents. Id.We held that such expenditures were capital expenditures, because
"they secure for the partnerships the right to receive benefits
under each lease that last well beyond the taxable year of the
expenditure." Id.Costs associated with the origination of the loans
contribute to the generation of interest income and provide a
long-term benefit that the banks realize over the lives of the
underlying loans. The resulting stream of income extends well
beyond the year in which the costs were incurred. It was this
income benefit that was the primary purpose for incurring these
expenditures.23 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. Therefore, like the
appraisal costs in Woodward v. Commissioner, supra, and United
States v. Hilton Hotels Corp., supra, the construction-related
depreciation in Commissioner v. Idaho Power Co., supra, and the
lease acquisition costs in Strouth v. Commissioner, supra, the
23
Petitioner argues that because the banks used the loan
application process as an opportunity to sell other services and
products, the costs associated with that function are not capital
expenses. Petitioner does not attempt to define which costs are
related to loan origination and which are related to other
selling costs. However, SFAS 91, par. 6 provides that the direct
loan origination costs consist only of those costs related to
activities "that would not have been incurred but for that loan."
(Emphasis added.) Therefore, by definition, the costs at issue
do not include additional selling expenses.
36
loan origination costs herein must be assimilated into the cost
of the asset created.
Capitalizing expenditures which are connected with the
creation of an asset having an extended life is an important
factor in determining net income. As the Court of Appeals for
the Eleventh Circuit observed:
The function of these rules is to achieve an accurate
measure of net income for the year by matching outlays
with the revenues attributable to them and recognizing
both during the same taxable year. When an outlay is
connected to the acquisition of an asset with an
extended life, it would understate current net income
to deduct the outlay immediately. To the purchaser,
such outlays are part of the cost of acquisition of the
asset, and the asset will contribute to revenues over
an extended period. Consequently, the outlays are
properly matched with revenues that are recognized
later and, to obtain an accurate measure of net income,
the taxpayer should deduct the outlays over the period
when the revenues are produced. [Ellis Banking Corp.
v. Commissioner, supra at 1379.]
The same is true here. The costs at issue are directly connected
to the creation of loans, which constitute separate and distinct
assets that are the banks' primary source of income. Revenues,
in the form of interest payments, are received over the life of
the individual loans. In order to accurately measure the banks'
net income, the direct costs of originating the loans must be
capitalized and amortized over the life of the loans.
Change in Method of Accounting
Petitioner contends that because the banks have consistently
deducted the costs at issue and, in so doing, have been acting in
37
accordance with established industry practice that has been in
effect for decades, respondent's characterization of these costs
as capital expenditures would amount to a change in its
accounting "methods" contrary to section 446. Section 446(a)
permits a taxpayer to compute taxable income "under the method of
accounting on the basis of which the taxpayer regularly computes
his income in keeping his books." A taxpayer's "method of
accounting" includes not only the overall method of accounting,
but also the accounting treatment of any item. Sec. 1.446-
1(a)(1), Income Tax Regs. However, section 446(b) provides in
effect that if the taxpayer's method does not clearly reflect
income, the Secretary may redetermine and recompute the taxable
income under a method which, in his opinion, does clearly reflect
income.24 Section 446(b) imposes a burden of proof upon
petitioner to demonstrate that respondent abused his discretion
in changing petitioner's accounting method. Resnik v.
Commissioner, 66 T.C. 74, 78 (1976), affd. per curiam 555 F.2d
634 (7th Cir. 1977). Petitioner's burden of proof is heavier
than merely proving that the determination of the Commissioner
was erroneous. Seligman v. Commissioner, 84 T.C. 191, 199-200
n.9 (1985), affd. 796 F.2d 116 (5th Cir. 1986).
In Electric & Neon, Inc. v. Commissioner, 56 T.C. 1324(1971), affd. without published opinion 496 F.2d 876 (5th Cir.
1974), the taxpayer improperly characterized capital expenditures
24
Respondent argues that the adjustments in these cases are
based on sec. 263(a), and not on his authority under sec. 446(b).
38
(costs the taxpayer incurred in constructing signs with respect
to which it was the lessor) as current deductions.25 Despite
this error, the taxpayer requested that we approve its accounting
method on the grounds that its method "clearly reflected income
over a period of years, and that such practices had been
consistently used over a long period of time." Id. at 1333. In
holding that the taxpayer's improper characterization of capital
expenditures failed to reflect income clearly, we stated:
As a result of its use of an improper method, E & N's
taxable income would be seriously understated in a year
when many new signs were constructed for lease, and
just as seriously overstated in a year when very few
signs were constructed, with the result of making the
corporation's financial fortunes appear to be sinking
when in fact it was enjoying great success, and rising
when in fact its business was seriously diminished.
* * * "Income must be reflected with as much accuracy
as recognized methods of accounting permit." Fort
Howard Paper Co. [v. Commissioner], 49 T.C. 275, 284
(1967); see also Caldwell v. Commissioner, 202 F.2d
112, 115 [(2d Cir. 1953)], affirming on this issue a
Memorandum Opinion of this Court. That E & N's
accounting method with respect to the treatment of the
cost of the leased signs fell short of this requirement
is obvious. [Electric & Neon, Inc. v. Commissioner,
supra at 1333.]
25
The taxpayer in Electric & Neon, Inc. v. Commissioner, 56
T.C. 1324 (1971), affd. without published opinion 496 F.2d 876(5th Cir. 1974), treated the entire costs of constructing the
signs it subsequently leased, including materials, supplies,
labor, freight, supervisory salary, workman's compensation
insurance, payroll taxes, licenses, and miscellaneous job costs,
as a current expense for Federal income tax purposes. Id. at
1326. Generally, the signs the taxpayer constructed had useful
lives substantially beyond the taxable year of construction and
the usual term for the original lease of these signs was 5 years.
Id. at 1332-1333.
39
We also pointed out in Electric & Neon, Inc. v. Commissioner,
supra at 1333:
while consistency is highly desirable when combined
with some acceptable method of accounting, it is not a
substitute for correctness; the respondent is justified
in requiring a change in a taxpayer's method of
accounting which, although consistently used over a
period of years, is erroneous, and does not clearly
reflect income.
Accordingly, we find that the banks' current deduction of
the costs associated with the origination of the loans did not
clearly reflect their income and, therefore, was not a proper
method of accounting.26 See also Commissioner v. Idaho Power
Co., 418 U.S. at 14 ("capitalization prevents the distortion of
income that would otherwise occur if depreciation properly
allocable to asset acquisition were deducted from gross income
currently realized."). It is apparent that the banks' current
deduction of the costs at issue improperly accelerated the tax
benefits derived from those costs and did not properly match the
costs with the interest income produced by the loans. We find
that capitalization of these expenses, subject to recovery by
means of amortization over the life of the loans, does clearly
reflect the banks' income and that respondent was within his
broad authority to require this change.
Legislative Necessity
26
We note that petitioner did not offer any evidence to show
how the current deduction of the costs at issue clearly reflects
the banks' income.
40
Petitioner's final argument is based on its observation
that, following our opinion in Iowa-Des Moines Natl. Bank v.
Commissioner, 68 T.C. 872 (1977), Congress has, on a number of
occasions, enacted specific legislation regarding the income
taxation of banks and other legislation that generally deals with
the capitalization of the costs of acquiring certain types of
assets,27 but has not availed itself of the opportunity to
address the deductibility of loan origination costs. Petitioner
argues that this, when coupled with the purported longstanding
industry practice of currently deducting costs like those in
issue, suggests that we should allow petitioner to continue to
deduct loan origination costs unless Congress acts to deny such
deductions. We disagree.
Petitioner's argument presupposes that because Congress has
not specifically addressed the deductibility of a particular item
over the years, it must mean that Congress intends for that item
to be currently deductible.28 Deductions, however, are matters
of legislative grace and are strictly construed and allowed only
when "'there is a clear provision therefor.'" INDOPCO, Inc. v.
27
For example, the capitalization provisions of sec. 263A
apply only to real and tangible personal property produced by the
taxpayer or real or personal property which is acquired for
resale. Sec. 263A does not apply to costs incurred by a
financial institution in originating loans. Sec. 1.263A-
2(a)(2)(i), Income Tax Regs.
28
Petitioner's argument also implies that we are somehow
departing from our opinion in Iowa-Des Moines Natl. Bank v.
Commissioner, 68 T.C. 872 (1977). However, as we explained supra
p.27, the expenditures at issue in that case did not create or
enhance a separate and distinct asset.
41
Commissioner, 503 U.S. at 84 (quoting Deputy v. du Pont, 308 U.S.
at 493). The fact that Congress has not chosen to act in this
area has no special relevance in these cases.
Conclusion
We have found that the expenditures at issue were incurred
in creating loans that were separate and distinct assets. We
hold that the banks were not entitled to deduct these
expenditures under section 162(a). Rather, they are to be
capitalized under section 263(a) and recovered through
amortization.
Decisions will be entered
under Rule 155.