The Problem
The year 2000 problem confronts the computer industry, (users, vendors and service providers) with a crisis having a magnitude possibly comparable to the S&L, environmental and asbestos crises. Briefly stated, the Year 2000 problem exists because of the use of a two-digit date scheme to save storage space and reduce the complexity of calculations, yielding better system performance. Many developers failed to anticipate that their systems would still be in service at the Year 2000, and did not account for the millennium change. Businesses with extensive information technology systems have tended to protect their technology investments by extending and evolving systems, not replacing them. Therefore, these technology systems rely on hardware and software for date-math calculations that have survived long past the life-cycles anticipated by their creators. The cost to fix the Year 2000 problem has been estimated to be $600 billion.
The Year 2000 problem raises a plethora of potential legal problems. This discussion focuses only on a narrow, but potentially very significant economic problem, the federal income tax consequences of a user's costs of effecting a Year 2000 fix. Neither Congress nor the courts has to date specifically addressed the tax treatment of Year 2000 fix costs, although the IRS in Rev. Proc. 97-50 published guidelines it will follow in reviewing tax returns with Year 2000-related project costs. Therefore, this discussion will offer general solutions under the IRS revenue procedure and under authorities which have evolved without regard to the particular facts and circumstances of the Year 2000 problem.
A company incurring costs for a Year 2000 fix will usually want a current tax write-off (or write-off over as short a term as possible) for all costs incurred. A write-off for tax purposes is determined under federal tax law and often has little correspondence to write-off for financial reporting purposes which is governed by generally accepted accounting principles or other accounting principles determined by various regulatory agencies. While there is language in the Internal Revenue Code and Treasury Regulations which appears to require conformity in book and tax accounting, there is a substantial body of authority which holds that accounting rules of regulatory agencies do not govern federal income tax consequences.[ 1]/ As contrasted with the preference for capitalization of Year 2000 costs for financial reporting purposes, most companies will find capitalization or long-term amortization of Year 2000 costs for tax purposes to result in an unacceptable bottom-line consequence.[ 2]/
For example, consider Company A, a California corporation, which has taxable income in 1996 before Year 2000 expenditures of $100 million and combined federal and state income tax of $40 million leaving $60 million of after-tax income. If Company A incurs $20 million of Year 2000 costs in 1996, and these costs are not deductible or amortizable, the after-tax income of Company A is now $40 million (Company A still pays tax on $100 million). If these costs are deductible, Company A's taxable income is $80 million, its combined federal and state tax is $32 million and its after-tax income is $48 million.
In short, Company A's after-tax income is reduced by 40% of its Year 2000 fix costs if these costs are not deductible or amortizable. If Company A's Year 2000 costs are amortizable over ten years, Company A can deduct $2 million per year for ten years, not as beneficial as current deductibility, but far preferable to no amortization deductions at all Deductibility of Year 2000 Costs
Failure to properly structure agreements for the Year 2000 fix can jeopardize eligibility for favorable treatment and exact a heavy tax cost. Year 2000 costs will only be tax deductible currently if they qualify under federal tax law as either "repairs," [ 3]/ or "research and development" costs for self-developed property under special provisions of tax law.[ 4]/ Each of these concepts is discussed below.
[a] Repairs
A repair expenditure is one which neither materially adds to the value of the property nor appreciably prolongs its life. Rather, a repair keeps the property in an ordinarily efficient operating condition.[ 5]/ Treasury regulation section 1.162-4 expressly provides that "repairs in the nature of replacements, to the extent that they arrest deterioration and appreciably prolong the life of the property, shall ... be capitalized and depreciated [in accordance with applicable rules] ... ."
The question of whether an expenditure is a deductible repair or an improvement which must be capitalized is a gray area which has generated a large body of case law. The ultimate resolution of this issue is very fact specific and will turn on the nature of the work done, the manner in which the work is reflected in contracts and how carefully the company documents the expenditures on its books and records. Unfortunately, new categories of big-ticket, repair-like expenses (such as Year 2000 fix costs), the deductibility of which have the potential to significantly impact U.S. tax revenue have not been greeted with clear position statements by the I.R.S. Historically, rulings on these issues for the initial five to ten years after exposure of the issue have tended to be generally unfavorable.[ 6]/
Although a sound argument will probably exist in many circumstances that Year 2000 costs qualify as deductible repair expenses, many companies are likely to face an uphill battle convincing the I.R.S. until and unless a clear position statement supporting deductibility is issued.[ 7]/ A company seeking to treat Year 2000 fix costs as deductible repairs should consult a tax adviser at the beginning of its Year 2000 fix process and maintain detailed current records of expenditures, making sure to reflect all information which supports repair treatment under existing authorities.
[b] Research and Development Costs
Qualification of Year 2000 costs as deductible research and development ("R&D") costs will be more promising in many circumstances, but requires the company to run the gauntlet of complex tax rules. Year 2000 fix agreements must be carefully structured to maximize chances of qualification, and a tax adviser should be consulted.
The rules are briefly summarized below. I.R.C. section 174(a) permits a taxpayer to elect to currently deduct R&D expenditures which are paid or incurred by it in connection with its trade or business even though these expenditures would ordinarily have to be capitalized. While there is some question as to whether computer software development costs are eligible for I.R.C. section 174(a) treatment, a 1969 I.R.S. revenue procedure (which reflects the current I.R.S. position on the deductibility of software development costs) permits the taxpayer to treat software R&D costs as deductible under I.R.C. section 174(a).[ 8]/ The IRS confirmed in Rev. Proc. 97-50 that "Year 2000 costs fall within the purview of Rev. Proc. 69-21."
Generally, the requirements under I.R.C. section 174(a) are as follows. First, the taxpayer must affirmatively elect to deduct all of its R&D expenditures on its income tax return for the first year R&D expenditures are made. A taxpayer which has not been currently deducting its R&D expenditures will have to obtain the consent of the I.R.S. to begin doing so. The I.R.S. appears to routinely give permission to make the change.[ 9]/ Retroactive changes will not be permitted.
Second, the expenditures must satisfy qualitative criteria as to what constitutes "research and experimental" expenditures. Treasury regulations define this term as "expenditures made in connection with the taxpayer's trade or business which represent research and development costs in the experimental or laboratory sense. Expenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development of a product. ... [T]he term product includes any pilot model, process, formula, invention, technique, patent, or similar property, and includes products to be used by the taxpayer in its trade or business ... ." Under the 1969 revenue procedure, eligible computer software includes all programs or routines used to cause a computer to perform a desired task or set of tasks and the documentation required to describe and maintain these programs.[ 10]/ One I.R.S. technical advice memorandum concludes that conversion of an existing software system constitutes development of computer software for this purpose and is eligible for treatment under the 1969 revenue procedure.[ 11]/ Specifically excluded expenditures tend generally to be of a routine nature and include those for efficiency surveys, management studies and ordinary testing and inspection for quality control.[ 12]/
Third, the R&D expenditures must be "paid or incurred" by the taxpayer. I.R.C. section 174(a) clearly applies not only to costs paid or incurred by the taxpayer for internal development, but also to amounts paid or incurred for R&D conducted on its behalf by another (i.e., an independent contractor).[ 13]/ However, R&D costs incurred in connection with the construction or manufacture of depreciable (amortizable) property by an independent contractor are deductible only if made "upon the taxpayer's order and at his risk."[ 14]/ Generally, this means there can be no guaranties or warranties as to the success of the results, leaving the taxpayer to bear the risks of success.[ 15]/ Much of a company's Year 2000 fix may be developed by independent contractors and will generate depreciable or amortizable property. In these circumstances, the R&D contracts must be examined carefully to assure satisfaction of the "at-risk" requirement. If a company decides to require the R&D contractor to bear the economic risk of success, then deductibility under I.R.C. section 174(a) or Revenue Procedure 69-21 will not be available, and the only possibilities for tax treatment of the costs will be current deductibility as repairs or amortization deductions discussed in the next section.
Amortization of Year 2000 Costs
If Year 2000 costs do not qualify as deductible repairs or R&D costs, they will not be currently deductible. The income tax consequences will again depend on how various agreements are structured. Year 2000 costs attributable under Year 2000 fix agreements to purchase or nondeductible development of computer software may be amortized over a three-year period.[ 16]/ Year 2000 costs attributable under Year 2000 fix agreements to be purchase or nondeductible development of other property may or may not be amortizable depending on the nature of the property.[ 17]/
For example, Year 2000 costs allocated to purchase or nondeductible development of a copyright (as contrasted with a copyrighted article) must be amortized over the life of the copyright - potentially a very long term unless the company can prove to the I.R.S. that the economic life is shorter.[ 18]/ All software is automatically copyrighted . what the company is buying as far as the I.R.S. is concerned depends on how the Year 2000 deal is structured.[ 19]/
The Research Tax Credit
The Internal Revenue Code currently allows a tax credit for qualifying research expenditures.[ 20]/ Under very limited circumstances and in limited amounts, costs for internally developed software may qualify.[ 21]/ The IRS confirmed its position in Rev. Proc. 97-50, stating that Year 2000 costs will only qualify for the research tax credit in "extraordinary circumstances." To the extent of the amount of research credit available, the credit is in lieu of the deduction for R&D expenditures, and in most cases, will be less advantageous.[ 22]/ In order to avoid reduction of the deduction for R&D expenditures, an annual election to reduce the research credit must be made.[ 23]/
Conclusion
Given the magnitude of the Year 2000 problem, it is possible that Congress will intervene to alleviate confusion regarding the tax treatment of fix costs and other Year 2000 tax issues. Until then, attempts will have to be made to apply the existing tax structure to these issues using authorities that do not quite fit or may be wholly inappropriate to the issues involved.
The positions taken by the IRS in Rev. Proc. 97-50 with respect to applicability of Rev. Proc. 69-21 to Year 2000 costs, and the general ineligibility of Year 2000 costs for the research tax credit are consistent with the information contained in this chapter. The guidance is welcome and provides a significant comfort level and useful tool for parties responsible for tax planning in connection with the structure of Year 2000 fix projects. For example, if the application of Rev. Proc. 69-21 to a user's Year 2000 costs involves a change in the user's accounting method, Rev. Proc. 97-50 states that the user must follow the automatic change in accounting method provisions of Rev. Proc. 97-37 in obtaining permission for the change.
Information contained in this article is current as of Jan. 5, 1998.
END NOTES
Thor Power Tool Co., 439 U.S. 522 (1978); Old Colony Railroad Co., 284 U.S. 552 (1932); and Rev. Rul. 84-24, 1984-1 C.B. 89. See also, I.R.S. Technical Advice Memorandum 9326001. See Joan Paul, Chapter 6, Federal Tax Considerations of Licensing Transactions, Drafting License Agreements, 3rd Edition, Aspen Law & Business, ' 6.04. Treas. reg. ' 162-4.
I.R.C. ' 174(a); Rev. Proc. 69-21, 1969-2 C.B. 303. Treas. reg. ' 162-4. Back to article
E.g., hazardous waste cleanup and asbestos removal costs. See I.R.S. Private Letter Rulings 9411002 and 9240004; but see Rev. Rul. 94-38, 1994-2 C.B. 35, modifying Rev. Rul. 88-57, 1988-2 C.B. 36. See Mt. Morris Drive-In Theatre Co., 25 T.C. 272; and n. 6, supra.
12 Treas. reg. ' 1.174-2(a)(3).
13 Treas. reg. ' 1.174-2(a)(8).
14 Treas. reg. ' 1.174-2(b)(3).
15 Id.; Private Letter Rulings 8614004 and 9449003.
16 See Chapter 6, Federal Tax Considerations of Licensing Transactions, supra, ' 6.04[e]; see also, Prop. Treas. reg. ' 1.167(a)-14(b) and 1.197-2(c)(4).
17 See Chapter 6, Federal Tax Considerations of Licensing Transactions, supra, ' 6.04.
18 See Chapter 6, Federal Tax Considerations of Licensing Transactions, supra, ' 6.04[c].
19 See Prop. Treas. reg. ' 1.861-18 and Norwest Corporation, 108 T.C. No. 18 (April 30, 1997).
20 I.R.C. ' 41, currently set to expire on May 31, 1997.
21
| See legislative history to I.R.C. ' 41(d), Prop. Treas. reg. ' 1.41-4(e) and United Stationers, Inc., 1997 U.S. Dist. Lexis 4299 (ND Ill., March 18, 1997) (involving internal-use software which did not qualify for the credit). The U.S. magistrate's opinion in March, 1997 disallowing the research tax credit for internal use software developed by United Stationers, Inc. was confirmed by the U.S. District Court in Illinois, although the District Court disagreed with some of the magistrate judge's reasoning and presented a different analysis. See United Stationers v. United States, No 92 C 6065 (N.D. Ill., October 17, 1997). While cutting back somewhat on the magistrate judge's expansive interpretation of the credit limitations, this case of first impression provides the IRS with strong encouragement for denying availability of the research tax credit for Year 2000 fix costs. |