Opinion ID: 2678309
Heading Depth: 3
Heading Rank: 2

Heading: Woodward, Idaho Power, and INDOPCO

Text: Nor must we revise Cleveland Allerton in light of the three other Supreme Court cases brandished by the government: Woodward v. Commissioner, 397 U.S. 572 (1970), Commissioner v. Idaho Power Co., 418 U.S. 1 (1974), and INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992). In Woodward, a majority of the stockholders of an Iowa publishing company voted to extend the company’s charter in perpetuity. 397 U.S. at 573. Iowa law required the majority to buy the stock of anyone voting against the extension. Id. The majority and dissenting stockholders could not agree on the value of the dissenters’ stock, so the majority brought an action in state court to determine the value. Id. The majority bought the stock at the price No. 13-1701 ABC Beverage Corp. v. United States Page 6 determined by the court and then claimed deductions for the attorneys’, accountants’, and appraisers’ fees related to the appraisal litigation. Id. at 573–74. The Supreme Court concluded that such expenses must be capitalized. The Court reasoned that “legal, brokerage, accounting, and similar costs incurred in the acquisition or disposition of [a capital asset] are capital expenditures” because those ancillary expenses “are as much part of the cost of that asset as is the price paid for it.” Id. at 576. To determine whether a litigation expense is part of the “cost of acquisition” of a capital asset, which must be capitalized, the Court asked whether the “origin of the claim litigated is in the process of acquisition itself,” rejecting the approach that would have instead focused on the taxpayer’s “primary purpose” for incurring the expense. Id. at 576–77. In the second case, Idaho Power, a public utility built facilities using its own construction equipment. 418 U.S. at 4–5. It wanted to deduct the cost of that equipment (i.e., the depreciation on the equipment) as a business expense, but the government disallowed the deduction. Id. at 5–6. The Court agreed with the government, emphasizing that “established tax principles require the capitalization of the cost of acquiring a capital asset,” including “the costs incurred in a taxpayer’s construction of capital facilities.” Id. at 12. Moreover, under the Tax Code, “an expenditure incurred in acquiring capital assets must be capitalized even when the expenditure otherwise might be deemed deductible” as a business expense. Id. at 17 (citing I.R.C. §§ 161, 167, 261, 263). The Court noted that the utility’s own accounting procedures, which were required by federal and state authorities, recognized construction-related depreciation as part of the cost of acquiring the asset. Id. at 14–15. The Court also found that a business who hired an independent contractor to build its facilities still would have to capitalize the construction-related depreciation. Id. at 14. “An additional pertinent factor” in favor of requiring a business who does its own construction work to capitalize construction-related depreciation was maintaining tax parity between the two. Id. Ultimately, the Court held that “the equipment depreciation allocable to taxpayer’s construction of capital facilities is to be capitalized.” Id. at 19. By implication, the Court permitted the equipment depreciation not allocable to the construction—for example, when the utility used the same equipment for operation and maintenance—to be deducted. No. 13-1701 ABC Beverage Corp. v. United States Page 7 Lastly, in INDOPCO, a chemical company sought to deduct investment banking, legal, and other costs it incurred in connection with its friendly takeover by another company. 503 U.S. at 81–82. The Court held that the costs must be capitalized. It began by noting that “deductions are exceptions to the norm of capitalization” and thus “are strictly construed and allowed only as there is a clear provision therefor.” Id. at 84 (internal quotation marks omitted). But it recognized that the “distinctions between current expenses and capital expenditures are those of degree and not of kind” and that “each case turns on its special facts.” Id. at 86 (internal quotation marks omitted). Moreover, one “undeniably important” inquiry is whether the taxpayer realizes benefits beyond the year in which it incurs the expenditure. Id. at 87. The Court found that the transaction at issue produced significant benefits to the chemical company that extended beyond the tax year in question, and thus, the Court held, “the acquisition-related expenses bear the indicia of capital expenditures and are to be treated as such.” Id. at 88–90. These three cases hold that litigation expenses necessary to purchase a capital asset, construction expenses necessary to build a capital asset, and professional expenses necessary to facilitate the takeover of a capital asset are capital expenditures. Contrary to the government’s position, these decisions do not require us to modify Cleveland Allerton. Nor does the reasoning of these cases dictate that we change Cleveland Allerton. The government argues that these decisions establish three principles: (1) deductions “are exceptions to the norm of capitalization” and are “strictly construed,” INDOPCO, 503 U.S. at 84; (2) “an expenditure incurred in acquiring capital assets must be capitalized even when the expenditure otherwise might be deemed deductible,” Idaho Power, 418 U.S. at 17, and regardless of the taxpayer’s motive for incurring the expense, Woodward, 397 U.S. at 576–77; and (3) tax parity is a “pertinent factor” in distinguishing deductions from capital expenditures, Idaho Power, 418 U.S. at 14. None of these principles squarely addresses the question presented today, and none requires that we modify Cleveland Allerton. First, while deductions must be strictly construed, the government agrees that a lease termination expense, by itself, would be deductible. In other words, the expense already fits within a specifically enumerated deduction in the Tax Code, I.R.C. § 162(a). The question of Cleveland Allerton, in contrast, was whether this otherwise deductible expense nonetheless had No. 13-1701 ABC Beverage Corp. v. United States Page 8 to be capitalized. INDOPCO’s statement about construing the reach of a statutory deduction, therefore, does not require us to change our prior precedent. Second, though otherwise deductible expenditures must be capitalized if they are incurred ancillary to acquiring a capital asset, the rule in Idaho Power does not prohibit a taxpayer from dividing an expense into capital and non-capital parts. The government argues that expenditures are indivisible and that the capital portion controls the expenditure’s tax treatment. But Idaho Power actually suggests the opposite. There, the Court required the taxpayer to divide its equipment expenditure into parts allocated to construction, which were to be capitalized, and parts allocated to operation and maintenance, which were to be deducted. See 418 U.S. at 19. And while Woodward tells us that ancillary expenses incurred in acquiring a capital must be capitalized, Cleveland Allerton has already made clear that a lease termination payment is not an ancillary expense. See 166 F.2d at 806, 807 (noting that the hotel made the payment “not for the real estate but to be relieved of an improvident rental obligation,” and characterizing the payment as “liquidated damages for release from contract”). The cases raised by the government do not require us to revisit that conclusion. Moreover, we disagree with the government that Cleveland Allerton relied on the taxpayer’s motive in a manner later rejected by Woodward. For one, it is not clear that Woodward’s “origin-of-the-claim” test applies outside the specific context of litigation expenses. See Woodward, 397 U.S. at 576–77. For another, Cleveland Allerton did not actually rely on the hotel’s motive to determine whether the expense should be capitalized. Rather, in the context of explaining how the hotel differed from a third-party taxpayer, the court noted that the lease was a liability the hotel sought to extinguish, and the payment was more akin to liquidated damages for release from contract rather than a capital investment. Cleveland Allerton, 166 F.2d at 806–07. Woodward and Idaho Power’s statements that otherwise deductible expense nonetheless must be capitalized do not require us to alter Cleveland Allerton. Third, Cleveland Allerton did consider tax parity. The court compared the hotel to a third-party purchaser, concluding that they were not alike. 166 F.2d at 806. The government agrees with the comparison but disagrees with the conclusion. In the government’s view, because the hotel and third-party purchaser would pay the same price for the property and lease, No. 13-1701 ABC Beverage Corp. v. United States Page 9 and the third-party purchaser would be required to capitalize the entire purchase price, the hotel should be required to capitalize the entire purchase price too. But though the hotel and thirdparty purchaser might pay the same price for the property and lease, they receive different benefits from their purchases, and that fact calls for different tax treatment. See INDOPCO, 503 U.S. at 87. Here, for example, both ABC and a third-party purchaser would pay $2.75 million simply to purchase the property, and both would be required to capitalize that cost. ABC and the thirdparty purchaser both might also pay $6.25 million simply to purchase the lease. Buying the lease, however, would yield distinct benefits. For ABC, the lease is a liability it extinguishes with the purchase. The government has already conceded that a lease termination expense standing alone would be deductible. In other words, the benefits ABC gains from owning the property outright do not make the expense capital in nature. For the third-party purchaser, in contrast, the lease is a capital asset capable of producing future income, in the form of rent payments from a lessee. The parties agree that such an expense must be capitalized. We recognized this precise difference in Cleveland Allerton, realizing that it called for different tax treatment. See 166 F.2d at 806–07. The lessee-purchaser is different from the third-party purchaser because owning the property outright is different than owning both the property and a long-term lease on the property with the lease’s attendant income stream. Idaho Power’s tax parity concern does not call for us to change Cleveland Allerton.