PNC Bancorp Inc. v. IRS Commissioner

Opinions of the United

2000 Decisions States Court of Appeals

for the Third Circuit

5-19-2000

PNC Bancorp Inc. v. IRS Commissioner

Precedential or Non-Precedential:

Docket 99-6020

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Filed May 19, 2000

UNITED STATES COURT OF APPEALS

FOR THE THIRD CIRCUIT

No. 99-6020

PNC BANCORP, INC.,

Successor to First National Pennsylvania Corporation

v.

COMMISSIONER OF INTERNAL REVENUE

(Tax Court No. 95-16002)

PNC BANCORP, INC.,

Transferee of Assets of First National Pennsylvania

Corporation

v.

COMMISSIONER OF INTERNAL REVENUE

(Tax Court No. 95-16003)

PNC BANCORP, INC.,

Successor to United Federal Bancorp, Inc., and

Subsidiaries

v.

COMMISSIONER OF INTERNAL REVENUE

(Tax Court No. 96-16109)

PNC BANCORP, INC.,

Transferee of Assets of United Federal Bancorp, Inc., and

Subsidiaries

v.

COMMISSIONER OF INTERNAL REVENUE

(Tax Court No. 96-16110)

PNC Bancorp, Inc., as (i) Successor to First National

Pennsylvania Corporation, (ii) Transferee of Assets of First

National Pennsylvania Corporation, (iii) Successor to

United Federal Bancorp, Inc., and Subsidiaries, and (iv)

Transferee of Assets of United Federal Bancorp, Inc.,

and Subsidiaries,

Appellant

On Appeal from the Commissioner of Internal Revenue,

Decision of the United States Tax Court

(Tax Court Nos. 95-16002, 95-16003, 96-16109,

and 96-16110)

Tax Court Judge: Honorable Robert P. Ruwe

Argued October 21, 1999

Before: SLOVITER, RENDELL, Circuit Judges,

and BYRNE, District Judge*

(Filed: May 19, 2000)

Robert J. Jones, Esq. (ARGUED)

Roger P. Colinvaux, Esq.

Arnold & Porter

555 12th Street, N.W.

Washington, DC 20004

Attorneys for Appellant

Richard Farber, Esq.

Annette M. Wietecha, Esq.

(ARGUED)

U.S. Department of Justice

Tax Division

P.O. Box 502

Washington, DC 20044

Attorneys for Appellee

_________________________________________________________________

* The Honorable Wm. Matthew Byrne, Jr., United States Senior District

Judge for the Central District of California, sitting by designation.

2

Michael F. Crotty, Esq.

American Bankers Association

1120 Connecticut Avenue, N.W.

Washington, DC 20036

Attorney for Amicus-Appellant

American Bankers Association

Maureen E. Mahoney, Esq.

Latham & Watkins

1001 Pennsylvania Avenue, N.W.

Suite 1300

Washington, DC 20004

Attorney for Amicus-Appellant

National Association of

Manufacturers

Ronald W. Blasi, Esq.

Georgia State University

College of Law

P.O. Box 4037

Atlanta, GA 30302

Attorney for Amicus-Appellant

Ronald W. Blasi

OPINION OF THE COURT

RENDELL, Circuit Judge.

In this appeal from a decision of the Tax Court, we are

asked to determine whether certain costs incurred by

banks for marketing, researching and originating loans are

deductible as "ordinary and necessary expenses" as

provided by section 162 of the Internal Revenue Code, 26

U.S.C. S 162 (1988), or whether these expenses must be

capitalized under section 263 of the Code. Two banks that

were predecessors in interest of appellant PNC Bancorp,

Inc. deducted these costs as ordinary business expenses.

The Internal Revenue Service disallowed the deductions and

issued statutory notices of deficiency. PNC filed petitions for

redetermination with the Tax Court. The Tax Court

determined that the expenses in question were not

deductible, but, instead, must be capitalized and amortized

3

over the life of the subject loans. PNC now appeals from

this determination.

We hold that the costs at issue were deductible as

"ordinary and necessary" expenses of the banking business

within the meaning of Internal Revenue Code section 162,

and that these costs do not fall within the purview of

section 263. Accordingly, we will reverse the judgment of

the Tax Court.

I. Genesis of the Dispute

The costs that the banks seek to deduct are the internal

and external costs that they incur in connection with the

issuance of loans to their customers. These costs,

discussed in more detail below, are a routine part of the

banks' daily business, and the services procured with these

outlays have been integral to the basic execution of the

banking business for decades.

The general contours of banks' involvement in making

loans have not changed dramatically in recent years, and

the relevant sections of the Tax Code have remained largely

unchanged. Historically, the costs at issue have been

deductible in the year that they are incurred; however, the

Commissioner rejected this tax treatment by PNC. Why is

the Commissioner now insisting upon capitalization of

these costs?

There are two relatively recent developments that appear

to have emboldened the Internal Revenue Service to pursue

capitalization of such costs. One of these developments is

the Supreme Court's opinion in INDOPCO, Inc. v.

Commissioner, 503 U.S. 79 (1992), in which the Court held

that expenses incurred by a target corporation in the

course of its friendly acquisition by another entity were not

currently deductible. See id. at 90. INDOPCO, which

signaled that the Supreme Court's previously announced

tests for capitalization were not exhaustive, may well have

been viewed by the IRS as a green light to seek

capitalization of costs that had previously been considered

deductible in a number of businesses and industries. This

phenomenon has not escaped comment from observers.

See, e.g., W. Curtis Elliott Jr., Capitalization of Operating

4

Expenses After INDOPCO: IRS Strikes Again, S.C. Law.,

Sept./Oct. 1993, at 29, 29, 30 (commenting on the IRS's

"recently aggressive posture on capitalization" after

INDOPCO, and noting that while the INDOPCO decision

itself was not "necessarily troubling," the IRS's

interpretation of it has stretched far beyond the scenario

presented in INDOPCO); IRS Loses Battle in INDOPCO War:

Advertising Remains Deductible, Taxes on Parade, July 16,

1998, at 1 (describing the "IRS's INDOPCO-fueled

juggernaut"). Thus, INDOPCO ushered in an era of generally

more aggressive IRS pursuit of capitalization.

An additional development may have prompted the IRS's

assertive posture in the more specific case of the loan

origination costs at issue here. This second development

was the Financial Accounting Standards Board's

promulgation of a new standard for financial accounting

treatment of loan origination costs, Statement of Financial

Accounting Standards No. 91 ("SFAS 91").1 Beginning in the

late 1980s, SFAS 91 required for the first time that, for

financial accounting purposes, loan fee income and the

costs incurred in connection with loan origination should

be deferred and recognized over the life of the loan, rather

than being recognized in full in the year the loan closed.2

The FASB's authority extends only to financial accounting

standards and not to tax accounting standards. For the

first few years of SFAS 91's existence, the IRS did not

require capitalization of the loan origination costs described

in this financial accounting standard. However, the IRS

apparently viewed INDOPCO as a reason to pursue

capitalization of the costs that SFAS 91 requires to be

deferred.3 Thus, the stage for this litigation was set.

_________________________________________________________________

1. The Financial Accounting Standards Board ("FASB") is an independent

private sector organization that establishes standards for financial

accounting and reporting. The Securities and Exchange Commission

recognizes the FASB's financial accounting standards as authoritative.

See UAW Local No. 1697 v. Skinner Engine Co., 188 F.3d 130, 136 n.4

(3d Cir. 1999).

2. SFAS 91 became effective for accounting years that began after

December 15, 1987.

3. Although the Commissioner and the Tax Court both claimed that they

were not relying on the financial accounting standards of SFAS 91 in

5

II. Factual Background

PNC Bancorp, Inc. (PNC) is a bank holding company

incorporated in Delaware. See A. at 102. Two smaller

banking entities, First National Pennsylvania Corporation

(FNPC) and United Federal Bancorp, Inc. (UFB), were

merged into PNC in 1992 and 1994, respectively, and PNC

succeeded to the liabilities of both these companies. See A.

at 103, 105. The activities at issue in this case occurred

before the mergers and were performed by FNPC and UFB

or their subsidiaries.4

The costs challenged in this appeal were incurred by both

banks in connection with the origination of loans. 5 There

are two categories of such "loan origination costs," as they

have been called.6 The first category includes payments

made to third parties for activities that help the bank

determine whether to approve a loan (credit screening,

property reports, and appraisals) and for the recording of

security interests when the bank decides to issue a secured

_________________________________________________________________

determining the tax treatment of the costs at issue, the IRS appears to

have imported the result of these financial accounting standards into the

tax arena without engaging in independent analysis of why these costs

should be subject to different tax treatment than the majority of

everyday business costs, and without considering the secondary tax

ramifications that would flow from a requirement of capitalization. See

infra note 16; see also Tr. of Oral Argument at 27 (conceding that SFAS

91 effectively determined where the IRS would "draw the line" between

deductibility and capitalization in this case).

4. For FNPC, the tax years at issue are 1988 and 1990; for UFB, the

years at issue are 1990, 1991, 1992 and 1993.

5. The IRS contested FNPC's claimed deductions for origination of both

consumer and commercial loans, but contested UFB's deductions only

for costs incurred in originating consumer loans. See A. at 137. The Tax

Court opinion noted that it was unclear why the IRS pursued

commercial loan activities only in the case of one of the two banks. See

PNC Bancorp, Inc. v. Commissioner, 110 T.C. 349, 355 n.9 (1998).

6. The parties disagree as to the appropriate name for this collection of

costs -- the Commissioner prefers "loan origination expenses," while PNC

prefers "risk management and marketing costs." However, as there is no

dispute about which costs are included in this group, the disagreement

is largely semantic. In this opinion, we will use the terms "loan

origination costs" or "loan marketing costs" to denote the costs at issue.

6

loan. The second category consists of internal costs, namely

that portion of employee salaries and benefits that can be

attributed to time spent completing and reviewing loan

applications, and to other efforts connected with loan

marketing and origination.7 The Commissioner pursued

capitalization of loan origination costs only when those

costs were incurred in connection with a loan that was later

approved; the Commissioner allowed the banks to deduct

origination costs expended in connection with loans that

were not successfully approved. See PNC Bancorp, Inc. v.

Commissioner, 110 T.C. 349, 359, 362 (1998); see also Tr.

of Oral Argument at 7.

Loan interest constituted the largest source of revenue

for each bank during the relevant time period, and interest

on deposits and other borrowing constituted the largest

expense. See A. at 108.8 It is undisputed that banks

generally can be profitable only if they successfully manage

their "net interest margin" -- the difference between

interest earned and interest paid. A profitable bank's net

interest margin plus its revenues from fees and other

sources must exceed its losses on loans and investments.

See A. at 108.

Bank personnel routinely undertook loan marketing

activities in tandem with other marketing and customer

service functions. Both tellers and "platform employees"

(those bank employees who have desks apart from the teller

windows) were encouraged to "cross-sell," that is, to sell

multiple products to existing and new customers who came

to the bank in search of a particular product or service. For

example, if a new customer opened a checking and savings

account, the bank representative might also suggest a

certificate of deposit or a loan. Likewise, when a consumer

applied for a loan, the employee taking the application was

_________________________________________________________________

7. The parties have stipulated to most of the facts concerning the loan

origination activities and the role that loan origination plays in the

banking business.

8. As the Tax Court put it, the banks' "principal businesses . . .

consisted of accepting demand and time deposits and using the amounts

deposited, together with other funds, to make loans." PNC, 110 T.C. at

351.

7

also expected to sell other bank products and services

(such as checking accounts, credit lines, or ATM cards)

during that same session. The banks provided financial

incentives to their tellers and platform employees for each

successful "cross-sale," see A. at 110, and such "cross-

sales" were a routine part of each bank's daily business.9

Before 1988, FNPC and UFB treated their loan

origination costs in the same manner as their other routine

expenses, both for tax accounting and financial accounting

purposes. That is, they reported these costs for the tax year

(and the fiscal year) in which the costs were incurred. This

practice was apparently standard in the banking industry

at that time. See A. at 169. In 1988, following the

promulgation of SFAS 91, FNPC and UFB began to separate

out their loan origination costs for financial accounting and

reporting purposes in order to conform with SFAS 91's

requirements. However, both banks continued to deduct

loan origination costs for tax purposes in the tax year in

which the loan closed. See A. at 124, 134. It is these

deductions that the Commissioner and the Tax Court

disallowed.

III. Jurisdiction and Standard of Review

The Tax Court had jurisdiction over PNC's petitions for

redetermination pursuant to 26 U.S.C. SS 6213 and 7442.

We have appellate jurisdiction pursuant to 26 U.S.C.

S 7482(a)(1), which states that "[t]he United States Courts of

Appeals . . . shall have exclusive jurisdiction to review the

decisions of the Tax Court . . . in the same manner and to

the same extent as decisions of the district courts in civil

actions tried without a jury." Thus, we have plenary review

over the Tax Court's findings of law, including its

construction and application of the Internal Revenue Code.

See National Starch & Chem. Corp. v. Commissioner, 918

F.2d 426, 428 (3d Cir. 1990), aff 'd, INDOPCO, Inc. v.

Commissioner, 503 U.S. 79 (1992). We review the Tax

Court's factual findings and inferences for clear error. See

_________________________________________________________________

9. At UFB, the average number of products and services sold to a new

customer at a loan session was six, including the loan. See A. at 53.

8

id.; see also Pleasant Summit Land Corp. v. Commissioner,

863 F.2d 263, 268 (3d Cir. 1988).

IV. Discussion

There is a fundamental distinction between business

expenses and capital outlays. The primary consequence of

characterizing a payment as a business expense or a

capital outlay "concerns the timing of the taxpayer's cost

recovery," INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 83

(1992): business expenses are deductible in the year in

which they are incurred, whereas a capital outlay is

generally "amortized and depreciated over the life of the

relevant asset, or, where no specific asset or useful life can

be ascertained, is deducted upon dissolution of the

enterprise," id. at 83-84.

Two sections of the Internal Revenue Code address the

deductibility vel non of expenditures such as those incurred

by FNPC and UFB. Section 162 of the Internal Revenue

Code provides in pertinent part: "There shall be allowed as

a deduction all the ordinary and necessary expenses paid

or incurred during the taxable year in carrying on any trade

or business . . ." 26 U.S.C. S 162(a). Section 263 of the

Code states that capital expenditures, i.e.,"amount[s] paid

out for new buildings or for permanent improvements or

betterments made to increase the value of any property or

estate," cannot be currently deducted. 26 U.S.C.S 263(a)(1).

It is true that these two sections are neither all-inclusive

nor mutually exclusive. See General Bancshares Corp. v.

Commissioner, 326 F.2d 712, 716 (8th Cir. 1964) (written

by then-Judge Blackmun). For example, it is possible that

an expense that might appear to be deductible under

section 162(a) might instead be required to be capitalized

because it also properly falls under the description provided

by section 263(a). If an expense were to fall under the

language of section 263(a), that section would "trump" the

deductibility provision of section 162(a) and the expense

would have to be capitalized. Thus, in order to be

deductible, the expense must both be "ordinary and

necessary" within the meaning of section 162(a) and fall

outside the group of capital expenditures envisioned by

9

section 263(a).10 Nonetheless, the two sections represent the

archetypes of the two opposing alternatives for tax

treatment of expenditures -- deduction and capitalization

-- and, ordinarily, an expenditure will fall under one or the

other section, not both.

The taxpayer bears the burden of showing that a given

expenditure is deductible. See Interstate Transit Lines v.

Commissioner, 319 U.S. 590, 593 (1943), quoted in

INDOPCO, 503 U.S. at 84. In order to demonstrate

deductibility under section 162(a) of the Code, the taxpayer

must meet a five-part test. "To qualify as an allowable

deduction under S 162(a) . . . , an item must (1) be `paid or

incurred during the taxable year,' (2) be for `carrying on any

trade or business,' (3) be an `expense,' (4) be a`necessary'

expense, and (5) be an `ordinary' expense." Commissioner v.

Lincoln Sav. & Loan Ass'n, 403 U.S. 345, 352 (1971). It is

clear that PNC's loan origination expenses can satisfy the

first four parts of this test.11 The question before us under

S 162, then, is whether these expenses qualify as "ordinary"

business expenses within the meaning of that section.

In determining what expenditures qualify as "ordinary,"

we must look to the particular facts of the case before us,

including the particular puzzle posed by the circumstances

of the banking industry. As Justice Cardozo stated nearly

seventy years ago in interpreting an earlier version of this

long-standing Code provision, ordinariness is "a variable

affected by time and place and circumstance." Welch v.

Helvering, 290 U.S. 111, 113-14 (1933). In interpreting the

_________________________________________________________________

10. Section 161 of the Code provides the appropriate method for reading

the two provisions in sequence: "In computing taxable income [ ], there

shall be allowed as deductions the items specified in this part, subject

to the exceptions provided in part IX (sec. 261 and following, relating to

items not deductible)." 26 U.S.C. S 161. Therefore, an expense that is

judged ordinary and necessary under section 162 can be deducted only

if it also does not trigger any of the capitalization provisions beginning

in section 261.

11. The requisite showing that an expense is"necessary" is a minimally

burdensome one; to meet it, a taxpayer need show only that the

expenditures were "appropriate and helpful." Welch v. Helvering, 290

U.S. 111, 113 (1933) (citing McCulloch v. Maryland, 17 U.S. (4 Wheat.)

316 (1819)).

10

Code, we should not stray from the moorings of the

"natural and common meaning" of the term "ordinary," id.

at 114, and in doing so must examine the nature of the

day-to-day operations of the particular business being

considered. See also Deputy v. du Pont, 308 U.S. 488, 495-

96 (1940) (stating that each case "turns on its special

facts," and that an expense that is ordinary-- "normal,

usual, or customary" -- in one business may not be

ordinary in another). Justice Cardozo's oft-quoted words

regarding the heavily case-specific nature of this inquiry are

no less appropriate today than they were in 1933:

Here, indeed, as so often in other branches of the law,

the decisive distinctions are those of degree and not of

kind. One struggles in vain for any verbal formula that

will supply a ready touchstone. The standard set up by

the statute is not a rule of law; it is rather a way of life.

Life in all its fullness must supply the answer to the

riddle.

Welch, 290 U.S. at 114-15; see also Commissioner v. Lincoln

Sav. & Loan Ass'n, 403 U.S. 345, 353 (1971). Accordingly,

we pursue a real-life inquiry into whether the expenditures

associated with loan marketing and origination are

"ordinary" expenses incurred in the day-to-day

maintenance of a bank's business.

The Commissioner has conceded that loan interest was

the banks' largest revenue source during the period in

question, and that interest payments on deposits and other

borrowing were their largest expense. There is no reason to

suppose that this time period was any different from any

other in this regard. Further, maximizing the "net interest

margin" -- the difference between interest received and

interest paid out -- is the principal manner in which banks

earn their keep. As the Tax Court stated, "[t]he principal

businesses of [the banks] consisted of accepting demand

and time deposits and using the amounts deposited,

together with other funds, to make loans." PNC, 110 T.C. at

351. Modern banks are essentially dealers in money. See

United States v. Philadelphia Nat'l Bank, 374 U.S. 321, 326,

327 n.5 (1963).

Given this context, the ordinary nature of the costs at

issue, routinely incurred in the banks' businesses, would

11

seem clear. In order to ensure deductibility, however, we

must also ascertain whether these costs were expended for

betterments to increase the value of property in a way that

would require these costs' capitalization underS 263. We

cannot conclude that in performing credit checks,

appraisals, and other tasks intended to assess the

profitability of a loan, the banks "stepped out of [their]

normal method of doing business" so as to render the

expenditures at issue capital in nature. Encyclopaedia

Britannica, Inc. v. Commissioner, 685 F.2d 212, 217 (7th

Cir. 1982). As we stated in National Starch, an important

determination is whether given expenditures "relate to the

corporation's operations and betterment into the indefinite

future," indicating the need for capitalization, or are instead

geared toward "income production or other current needs,"

suggesting deductibility. National Starch & Chem. Corp. v.

Commissioner, 918 F.2d 426, 433 (3d Cir. 1990), aff 'd,

INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992). The

facts before us demonstrate that loan operations are the

primary method of income production for the subject

banks. We have no doubt that the expenses incurred in

loan origination were normal and routine "in the particular

business" of banking. See Deputy v. du Pont , 308 U.S. at

496.

The Commissioner argues, and the Tax Court found, that

the Supreme Court's decision in Lincoln Savings requires a

different result. We disagree. In Lincoln Savings, the

Supreme Court concluded that payments made by Lincoln

Savings and Loan Association into a "Secondary Reserve"

fund at the Federal Savings and Loan Insurance

Corporation (FSLIC) were not deductible as ordinary

business expenditures. See Lincoln Savings, 403 U.S. at

354, 359. In so holding, the Court upheld the IRS's

distinction between payments that Lincoln made into the

FSLIC's "Primary Reserve," which the IRS had found to be

deductible as ordinary and necessary expenses, and those

payments made into the "Secondary Reserve," found to be

capital expenditures. The Court engaged in an extensive

analysis of the nature of each reserve fund and the

premium payments made into each by Lincoln Savings and

other similarly situated FSLIC-insured institutions. The

Court noted that the "only concern" was whether the

12

premium payment to the Secondary Reserve "was an

expense and an ordinary one within the meaning ofS 162(a)

of the Code." Lincoln Savings, 403 U.S. at 354. The Court

noted that the fact that many institutions were required to

make such a Secondary Reserve premium did not render

that premium an ordinary expense, see id. at 358; nor did

the fact that the premium could have some ensuing benefit

to Lincoln Savings, in and of itself, render the premium a

capital expenditure, see id. at 354 ("many expenses

concededly deductible have prospective effect beyond the

taxable year"). Rather, the Court focused on what the

payment represented in the context of Lincoln Savings'

business and of the "structure and operation of FSLIC's

reserves":

What is important and controlling, we feel, is that the

[Secondary Reserve] payment serves to create or

enhance for Lincoln what is essentially a separate and

distinct additional asset and that, as an inevitable

consequence, the payment is capital in nature and not

an expense, let alone an ordinary expense, deductible

under S 162(a) in the absence of other factors not

established here.

Id.12 Whereas Lincoln Savings and the other insured

institutions had no property interest in the Primary

Reserve, each did have an earmarked property interest in

the Secondary Reserve that was carried as an asset on each

institution's books, was enhanced by each institution's

contribution, and was refundable to that institution in

certain circumstances.

In the case at bar, the Tax Court concluded without any

elaboration that the consumer and commercial loans

"clearly" were separate and distinct assets of the banks, see

PNC, 110 T.C. at 364, and that the costs incurred in

originating and processing the loans "created" these

_________________________________________________________________

12. Interestingly, while the Court did not discuss the issue in terms of

the provisions of S 263, in determining that the asset was "capital in

nature," the Court necessarily engrafted its thinking on the meaning of

capital assets under that section of the Code. In fact, the Supreme Court

has subsequently described Lincoln Savings' holding as stemming from

an analysis of S 263 as well as S 162. See INDOPCO, 503 U.S. at 86-87.

13

separate and distinct assets, see id. at 366. We believe that

the Tax Court took too broad a reading of what Lincoln

Savings meant by "separate and distinct assets," as well as

an overbroad reading of what can be said to "create" such

assets.

The Secondary Reserve fund in Lincoln Savings was a

"separate and distinct asset" in two important ways that

distinguish it from FNPC's and UFB's loans, the assets in

question here. First, the Secondary Reserve fund was an

asset that existed quite apart from Lincoln's main daily

business of taking deposits and making loans; second, the

fund was an asset that, although it existed within the

FSLIC, was nonetheless separate from the FSLIC's other

revenues and distinctly earmarked as Lincoln's property.

The Tax Court's broad reading of Lincoln Savings essentially

treats the term "separate and distinct asset" as if it extends

to cover any identifiable asset. We do not subscribe to this

reading of Lincoln Savings.

Furthermore, we do not agree that the marketing and

origination activities actually "created" the banks' loans in

the same way that the activities in Lincoln Savings created

the Secondary Reserve fund. In the instant case, the Tax

Court proceeded from the clearly accurate premise that the

expenses in question were associated with the loans,

incurred in connection with the acquisition of the loans, or

"directly related to the creation of the loans," PNC, 110 T.C.

at 368, to the faulty conclusion that these expenses

themselves created the loans. See id. at 364-68. We

conclude that the term "create" does not stretch this far. In

Lincoln Savings, it was the payments themselves that

formed the corpus of the Secondary Reserve; therefore, it

naturally follows that these payments "created" the reserve

fund. In PNC's case, however, the expenses are merely

costs associated with the origination of the loans; the

expenses themselves do not become part of the balance of

the loan. PNC argues persuasively that the Tax Court's

interpretation of the Lincoln Savings language is

inappropriately expansive:

While purporting to apply the Lincoln Savings

language, both the Tax Court and the government

effectively have transformed that language, by subtle

14

but significant degrees, from a test based on whether

a cost "creates" a separate and distinct asset, into a

much more sweeping test that would mandate

capitalization of costs incurred "in connection with" or

"with respect to" the acquisition of an asset.

PNC Reply Br. at 4. We decline to follow the Tax Court's

broad interpretation, for to do so would be to expand the

type of costs that must be capitalized so as to drastically

limit what might be considered as "ordinary and necessary"

expenses. We conclude, therefore, that the loan origination

expenses were ordinary expenses and that they did not

"create or enhance a separate and distinct asset" within the

meaning of Lincoln Savings.

A line of federal appellate opinions subsequent to Lincoln

Savings, involving factual scenarios not that different from

the one before us, supports our finding that Lincoln Savings

does not compel a conclusion that FNPC's and UFB's costs

should be capitalized. These cases, from the Fourth, Eighth

and Tenth Circuit Courts of Appeals, address the

deductibility of costs incurred in connection with credit

card issuance. In Iowa-Des Moines National Bank v.

Commissioner, 592 F.2d 433 (8th Cir. 1979), the Eighth

Circuit Court of Appeals found that payments by banks to

third parties who provided the banks with credit

information on prospective credit card customers were

deductible expenses under S 162. See id. at 436. The court

found that "[p]erhaps the most significant factor is that the

payments were for a service (credit screening) that could

have been performed by personnel employed by the

[banks]." Id. Because "[c]redit screening is a necessary and

ordinary part of the banking business . . . not a capital

expenditure," the Eighth Circuit Court of Appeals found

that fees paid to third parties for credit screening were

deductible. Id. The Iowa-Des Moines court seemed to

assume that such expenditures would a fortiori be

deductible if the bank's personnel were to perform the

credit screens themselves.13 The Fourth and Tenth Circuit

_________________________________________________________________

13. The Eighth Circuit Court of Appeals also emphasized the "short

useful life" of this credit information as a factor weighing in favor of

deductibility. Iowa-Des Moines, 592 F.2d at 436.

15

Courts of Appeals have reached similar conclusions. In First

National Bank of South Carolina v. United States, 558 F.2d

721 (4th Cir. 1977) (per curiam), the Fourth Circuit Court

of Appeals permitted the taxpayer bank to deduct start-up

assessments paid to a nonprofit association formed to

enable banks to combine their efforts in entering the credit

card field. See id. at 723. The association was charged with

centralizing billing and recordkeeping for the banks. The

Fourth Circuit Court of Appeals characterized the credit

card accounts that were the focus of this activity as being

a type of loan. See id. at 722. In Colorado Springs National

Bank v. United States, 505 F.2d 1185 (10th Cir. 1974), the

Tenth Circuit Court of Appeals allowed the deduction of

pre-operation expenditures for a nonprofit credit card-

related association that would cover expenses such as

computer costs, advertising, credit screening, and clerical

services. See id. at 1193. The Colorado Springs court found

that these expenses did not "create or enhance . . . a

separate and distinct additional asset," reasoning as

follows:

The start-up expenditures here challenged did not

create a property interest. They produced nothing

corporeal or salable. They are recurring. At the most

they introduced a more efficient method of conducting

an old business. . . .

. . . [T]he use of bank credit cards in consumer

transactions is a normal part of the banking business.

The challenged expenditures were for the continuation

of an existing business and for the preservation and

improvement of existing income. Hence, they were

ordinary expenses.

Id. at 1192-93.

In the case before us, the Tax Court distinguished these

"credit card" cases, stating that they were inapposite to our

fact pattern because in those cases, no "separate and

distinct asset" was created, while in PNC's case, such an

asset was created. As we have discussed above, we do not

agree that the loan origination expenditures created distinct

assets, any more so than did the expenditures incurred in

entering into the credit card business. In fact, wefind that

16

PNC's situation presents an even stronger case for

deductibility than do the credit card cases. In the credit

card cases, the taxpayers were starting up new programs

within their businesses, or at the very least, new methods

of performing old tasks. In contrast, FNPC and UFB

incurred the challenged costs in their routine selling and

marketing of normal loans in the traditional ways that

banks have been using for many decades.14 Thus, FNPC's

and UFB's costs bear far more of the indicia of

"ordinariness," and fewer of the indicia of"creating"

something, than do the start-up costs described in the

credit card cases.

The remaining question, then, is whether either the

Financial Accounting Standards Board's adoption of SFAS

91 or the Supreme Court's pronouncement on deductibility

in INDOPCO, both of which developments occurred after the

decisions in Lincoln Savings and the credit card cases,

would alter the calculus of deductibility versus

capitalization in PNC's case. We conclude that the existence

of SFAS 91 has little, if any, bearing on the appropriate tax

analysis, and that the Supreme Court's decision in

INDOPCO, while clearly relevant, does not change the result

in the case at bar.

The Supreme Court has held that financial accounting

standards such as SFAS 91 do not dictate tax treatment of

income and expenditures. See Thor Power Tool Co. v.

Commissioner, 439 U.S. 522, 542-43, 544 (1979)

(discussing the "vastly different objectives thatfinancial and

tax accounting have" and stating that "[g]iven this diversity,

even contrariety, of objectives, any presumptive equivalency

between tax and financial accounting would be

unacceptable" and would "create insurmountable

difficulties of tax administration"). The IRS concedes that

"financial accounting rules are not controlling for federal

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14. As the Tax Court decision that was affirmed by the Eighth Circuit

Court of Appeals in Iowa-Des Moines stated, costs that are "merely

related to the active conduct of an existing business and [do] not create

or enhance a separate and distinct asset or property interest" are

appropriate for deduction. Iowa-Des Moines Nat'l Bank v. Commissioner,

68 T.C. 872, 879 (1977), cited in PNC, 110 T.C. at 365.

17

tax purposes," IRS Br. at 28 n.4 (citing PNC , 110 T.C. at

364 n.15), and states that "[n]either the Commissioner's

deficiency determination nor the Tax Court decision was

based on the provisions of SFAS 91," id. Although SFAS 91

may have served as a catalyst for the IRS's desire to seek

capitalization of the costs at issue here, and may have been

considered by the IRS in determining where to draw the

line between current-year and deferred costs, see supra

note 3, the IRS disavows any argument that the financial

accounting standards should dictate tax treatment, see IRS

Br. at 27-28 & n.4. Further, as with the financial

accounting standards at issue in Thor Power, it is clear that

the reasons for SFAS 91's requirement that loan origination

costs be deferred are reasons wholly specific to the realm of

financial accounting,15 and thus those financial accounting

standards do not affect our tax analysis.16

_________________________________________________________________

15. SFAS 91 was motivated by a concern that the structure of certain

banks' loan agreements could lead to the illusion that these banks and

their customers were in better financial condition than they actually

were. Specifically, SFAS 91 was designed to address the practices of

banks that charged unusually high fees up front as conditions for the

closing of a loan (e.g., high "points" on a mortgage) in exchange for

lower

interest rates later on; these practices were known as "teaser" rate

financing. See A. at 173. These practices"arguably allowed individuals

to qualify for loans in greater amounts than they would otherwise be

able to secure," id., and also overstated the income from a loan in its

first year and understated its income in later years. The Financial

Accounting Standards Board, concerned about these ramifications,

therefore required companies to defer fees over the life of the loan. SFAS

91 was worded to include the deferral of costs only after industry

representatives protested that it would be unfair to the industries to

have to defer the fees they received without also being allowed to defer

the costs they incurred. See A. at 174.

16. In fact, we conclude that the IRS's wholesale importation of the line

drawn by the financial accounting standards creates tax consequences

that the Commissioner appears not to have considered. For example, if

the loan origination costs were required to be capitalized, it would seem

to follow that these costs would have to be included in the basis of each

loan. Such inclusions would apparently be a departure from current

practice. Cf. Rev. Rul. 89-122, 1989-2 C.B. 200 (apparently assuming

that the bank's basis in a loan is equal to the money advanced by the

bank, without any adjustments for origination costs). The calculations

18

Nor do we view the Supreme Court's decision in INDOPCO

as requiring a different result regarding the deductibility of

the banks' costs. In INDOPCO, the Supreme Court required

capitalization of the expenditures incurred by the target

corporation during a planned friendly takeover by another

company. See INDOPCO, 503 U.S. at 90. The Supreme

Court was careful to emphasize in INDOPCO, as it had in

Lincoln Savings, that the capitalization versus deductibility

inquiry was heavily fact-based. See id. at 86 (citing Welch

v. Helvering, 290 U.S. 111, 114 (1933) and Deputy v. du

Pont, 308 U.S. 488, 496 (1940)). The Supreme Court in

INDOPCO downplayed the importance of the "creation of a

separate and distinct asset" described in Lincoln Savings,

clarifying that it was not an exclusive test:

Lincoln Savings stands for the simple proposition that

a taxpayer's expenditure that "serves to create or

enhance . . . a separate and distinct" asset should be

capitalized under S 263. It by no means follows,

however, that only expenditures that create or enhance

separate and distinct assets are to be capitalized under

S 263.

INDOPCO, 503 U.S. at 86-87. The Court reasoned that,

while in the Lincoln Savings setting the Court had seemed

to attach limited significance to the concept of"benefit," see

INDOPCO, 503 U.S. at 87 (quoting Lincoln Savings, 403

U.S. at 354), in the merger situation presented in INDOPCO

a "future benefit" analysis was relevant and appropriate

since the "resource-related benefits" to be reaped from the

merger were of considerable importance, INDOPCO , 503

U.S. at 88. In the INDOPCO context of a friendly takeover,

_________________________________________________________________

involved would presumably complicate the transfer of loans from one

lending institution to another. However, the IRS conceded at oral

argument that a requirement of capitalization of loan origination costs

would probably mean that these complex basis adjustments would need

to be made. See Tr. of Oral Argument at 34. The IRS's apparent failure

to consider these and other tax ramifications of capitalization suggests

that the IRS's borrowing of the line that the SFAS 91 standards draw

between current-year costs and deferred costs was not based on any

independent tax analysis, but was simply a "bootstrapping" of the

financial accounting standards into the tax arena.

19

the Court found that one key inquiry was whether the

money that the target corporation had spent on takeover-

related expenditures was spent primarily for a "future

benefit" extending beyond the tax year, rather than for the

needs of current income production. The Court stated:

Although the mere presence of an incidental future

benefit -- "some future aspect" -- may not warrant

capitalization, a taxpayer's realization of benefits

beyond the year in which the expenditure is incurred is

undeniably important in determining whether the

appropriate tax treatment is immediate deduction or

capitalization.

Id. at 87.

As was recognized in several of the "credit card" cases

discussed above, these circumstances are simply not

presented by a bank's credit-issuing activities. The Eighth

Circuit Court of Appeals in Iowa-Des Moines, anticipating

the "future benefit" concerns later stated in INDOPCO,

emphasized the "short useful life" of credit information as a

reason for deductibility. Iowa-Des Moines, 592 F.2d at 436.

The Iowa court stated that the prospective future benefit

that could accrue beyond the taxable year as a result of

credit screening was "very slight," and thus capitalization

was "not easily supported." Id. In National Starch, the

decision that the Supreme Court affirmed in INDOPCO, we

found that these credit card cases contained the seed of the

"future benefit" analysis, citing these cases as evidence that

several Courts of Appeals "look[ed] to whether an ensuing

benefit was created to determine whether the expense was

ordinary and necessary," National Starch, 918 F.2d at 431,

and that these courts found that future benefit was not

substantial in situations similar to the case at bar. See id.

(citing Iowa-Des Moines and Colorado Springs). We conclude

that the credit card cases not only continue to have vitality

after INDOPCO, but in fact anticipated some of the concerns

addressed by INDOPCO.

We also conclude that the Tax Court erred in its

interpretation of the "future benefit" analysis by relying on

the fact that the loan itself was usually of several years'

duration and by reasoning that the loan origination costs

20

were, thus, essentially directed at future benefit. The Tax

Court stated: "While the useful life of a credit report and

other financial data may be of short duration, the useful life

of the asset they serve to create is not." PNC, 110 T.C. at

371. However, that analysis depends on the Tax Court's

earlier assumption that the loan origination expenses

actually created a "separate and distinct asset." Stripped of

this assumption, the Tax Court's analysis is not

supportable.17

In addition, we must remember that the "future benefit"

analysis adopted in INDOPCO is not meant as a talismanic,

bright-line test. See A.E. Staley Mfg. Co. v. Commissioner,

119 F.3d 482, 489 (7th Cir. 1997) ("[T]he Court did not

purport to be creating a talismanic test that an expenditure

must be capitalized if it creates some future benefit.").

Rather, the INDOPCO analysis demonstrates the contextual,

case-by-case approach to determining whether an

expenditure better fits under the "ordinary and necessary"

language of section 162(a) or the "permanent improvements

or betterments" language of 263(a). We conclude that the

loan origination expenses incurred by UFB and FNPC have

the characteristics of the former, rather than the latter,

statutory language.

As described above, the loan marketing activities at issue

here lie at the very core of the banks' recurring, routine

day-to-day business. The Commissioner has not been able

to articulate a principled reason why these normal costs of

doing business must be capitalized, while other ordinary

banking costs need not be. Instead, the Commissioner

relies on the line drawn by SFAS 91, a standard whose

rationale we conclude is far removed from the concerns of

the tax system. See, e.g., IRS Br. at 27 ("It should be noted

_________________________________________________________________

17. The Tax Court's "future benefit" discussion also reflects another

problematic assumption, i.e., that the capitalization requirement is

contingent on the loan's ultimately being approved. It cannot possibly be

true, as the Tax Court and the Commissioner would have it, that the

existence of a subsequent loan-derived revenue stream is the trigger for

the capitalization requirement. (If a company were to undertake research

and development to investigate new product lines, would it have to

capitalize only those R&D costs that led to product lines that were

ultimately successful and profitable? We think not.)

21

. . . that SFAS 91 itself, which the banks have followed,

expressly distinguishes direct loan origination costs, which

must be deferred, from all other loan-related costs, such as

advertising, soliciting potential borrowers, and servicing

existing loans, which may be currently deducted for

financial accounting purposes."); Tr. of Oral Argument at

27 (statement by IRS's counsel that "[w]here we draw the

line is -- actually the Financial Accounting Standards

Board made it very easy for us."). Similarly, the Tax Court,

while professing not to find the financial standards

dispositive, see PNC, 110 T.C. at 364 n.15, id. at 368 n.18,

used SFAS 91 as the sole source of an explanation as to

why these loan origination costs, but not other costs

associated with the banks' lending business, must be

capitalized, see id. at 368-69. We remain unconvinced that

the line drawn by the FASB in SFAS 91 has any relevance

here for tax purposes.

The Supreme Court has noted that "capitalization

prevents the distortion of income that would otherwise

occur if depreciation properly allocable to asset acquisition

were deducted from gross income currently realized."

Commissioner v. Idaho Power Co., 418 U.S. 1, 14 (1974). In

the case of the costs at issue here, there need be no

concern about a distortion of income because of the

regularity of these expenses.

Finally, we emphasize that the key to the deductibility

inquiry remains the statutory language of sections 162(a)

and 263(a). See Erwin N. Griswold, Cases and Materials on

Federal Taxation, at 15 (5th ed. 1960) ("There is no use in

thinking great thoughts about a tax problem unless the

thoughts are firmly based on the controlling statute."). The

analyses set forth in INDOPCO and Lincoln Savings provide

us with two applications of that statutory language. Like

the Supreme Court in INDOPCO and Lincoln Savings, we do

not here attempt to define once and for all a bright line

between deduction and capitalization that will hold true for

all factual situations. We can only heed Justice Cardozo's

admonition that we should always keep the factsfirmly in

view, as well as Dean Griswold's advice that we remain

cognizant of the language of the Code. Resorting to that

language, we find the case before us today to be much

22

farther from the heartland of the traditional capital

expenditure (a "permanent improvement or betterment")

than are the scenarios at issue in INDOPCO and Lincoln

Savings. We will not mechanistically apply phrases from

those precedents in ignorance of the realities of the facts

before us. We see no principled distinction between the

costs at issue here and other costs incurred as"ordinary

expenses" by banks.

V. Conclusion

For the foregoing reasons, we find that the loan

origination expenses are deductible as "ordinary and

necessary business expenses" under section 162(a) of the

Internal Revenue Code, and are not subject to the

capitalization provision of section 263(a). Accordingly, we

will reverse the judgment of the Tax Court.

A True Copy:

Teste:

Clerk of the United States Court of Appeals

for the Third Circuit

23