PRODUCT DESIGN PACKAGING EXPENSES MUST BE CAPITALIZED.

Rev. Rul. 89-23

ISSUES

(1) If expenditures are incurred after December 31, 1986, in connection with the development and design of product packages, are those expenditures deductible as ordinary and necessary business expenses under section 162(a) of the Internal Revenue Code in the tax year in which the expenditures are incurred, or must they be capitalized under section 263A of the Code? If expenses are incurred prior to January 1, 1987, must they be capitalized under section 263?

(2) If such expenditures must be capitalized under section 263 or section 263A of the Code, are they amortizable under section 1.167(a)-3 of the Income Tax Regulations?

FACTS

Corporation X is a domestic corporation that manufactures and markets consumer goods at retail. X files its federal income tax returns on a calendar year basis using an accrual method of accounting.

During 1986 and 1987, X introduced three new products, X incurred package design costs for each new product. Although the useful life of each package design could not be ascertained at the time it was placed in service, the useful life of each package design was more than one year.

The term "package design", as used in this revenue ruling, means an asset that is created by a specific graphic arrangement or design of shapes, colors, words, pictures, lettering, and so forth on a given product package, or the design of a container with respect to its shape or function.

The term "package design cost", as used in this revenue ruling, means the cost of package designs. If the taxpayer develops the package design, the term includes the cost of materials, labor, and overhead associated with the design, including all design exploration and study, refinement of the basic design selected, testing, and preparation of the final master comprehensive design. If an independent contractor performs the work, the term includes all billings related to the development of the particular package, including all design exploration and study, refinement of the basic design selected, testing, and preparation of the final master comprehensive design. If the taxpayer purchases the package design, the term includes the purchase price. (See also section 1.263A- 1T(a)(5)(ii) of the regulations that treats a taxpayer purchasing a package design as also producing such design to the extent the taxpayer incurs costs with respect to the design). The term, however, does not include costs associated with coupon inserts, refund offers, and other promotion-related changes, nor does it include costs that are unrelated to the package design itself, such as a change to the list of ingredients. Moreover, the term does not include costs that would have qualified as "trademark or trade name expenditures" under section 177 of the Internal Revenue Code of 1954 (the 1954 Code); such costs must be capitalized and recovered on a disposition of the asset.

In 1988, all three products were still currently marketed by X using the 1986 and 1987 package designs.

LAW AND ANALYSIS

Section 162 of the Code provides that there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business. Section 1.162-1(a) of the regulations provides that among the items included in business expenses are advertising and other selling expenses.

Section 263A of the Code and the regulations thereunder provide for the capitalization of certain direct and indirect costs with respect to real or tangible personal property produced by the taxpayer and certain property acquired for resale. Section 263A was enacted by the 1986 Act, section 803(a), 1986-3 (Vol. 1) C.B. 267. In general, section 263A is effective for costs incurred after December 31, 1986; in the case of property that is inventory in the hands of the taxpayer, the section is generally effective for tax years beginning after that date.

Section 1.263A-1T of the temporary Income Tax Regulations provides that all costs that directly benefit or are incurred by reason of the production of real or tangible personal property, or property that is acquired for resale, are to be capitalized with respect to that property. See section 1.263A-1T(b)(2)(iii), which provides examples of indirect costs that must be capitalized with respect to production or resale activities. See also section 1.263A- 1T)(b)(2)(iv), which provides generally that interest on debt incurred or continued to finance the production of real or tangible personal property to which such section otherwise applies must be capitalized.

Section 1.263A-1T(a)(5)(ii) states that the term "produce" includes construct, build, install, manufacture, develop, improve, create, raise or grow. Although section 263A of the Code does not require the costs of producing intangible personal property to be capitalized, section 263A(b) defines tangible personal property to include a film, sound recording, video tape, book, or similar property. For this purpose, tangible personal property includes property embodying words, ideas, concepts, images, or sounds. See section 1.263A-1T(a)(5)(iii) of the temporary regulations; see also 2 H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. II-308 (1986), 1986-3 (Vol. 4) C.B. 308. Moreover, section 1.263A-1T(a)(5)(iii) applies to the production of "tangible personal property" within the meaning of that provision without regard to whether that property is treated as tangible or intangible under other provisions of the Code. Thus, the requirements of section 1.263A-1T(a)(5)(iii) apply to the costs of the properties enumerated therein, although those costs may consist of copyrights, licenses, manuscripts, and other items that may be treated as intangible for other purposes of the Code.

Section 1.263A-1T(b)(4)(x) of the temporary regulations, in illustrating required allocations of administrative, service, and support costs to various activities, provides that the costs of engineering and design services are to be so allocated. See also section 1.263A-1T(b)(2)(iii)(S), which provides that engineering and design expenses (to the extent that such amounts are not research and experimental expenses as described in section 174 and the regulations thereunder) are indirect costs that must be capitalized with respect to production and resale activities.

If a taxpayer purchases a package design from another person after December 31, 1986, section 1.263A-1T(a)(5)(ii) of the temporary regulations treats the taxpayer as producing the package design to the extent that the taxpayer incurs costs (e.g., general and administrative costs, interest, etc.) with respect to the package design. The taxpayer must capitalize these costs, in addition to capitalizing the purchase price of the package design, as part of the total package design expenditures.

The above provisions of the Code and the temporary regulations require that expenses incurred after December 31, 1986, in connection with the development and design, or purchase, of product packages must be capitalized under section 263A of the Code for tax years ending after such date. On the other hand, for tax years not covered by section 263A and section 1.263A-1T of the temporary regulations, a similar result is required by section 263 and the regulations thereunder.

Section 263(a) of the Code provides that no deduction shall be allowed for any amount paid for permanent improvements made to increase the value of any property or estate. Section 1.263(a)-2 of the regulations provides examples of capital expenditures and includes the costs of acquiring property having a useful life substantially beyond the taxable year.

Section 167 of the Code provides that there shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence) of property used in the trade or business. Section 1.167(a)-3 of the regulations provides that if an intangible asset is known from experience or other factors to be of use in the business or in the production of income for only a limited period, the length of which can be estimated with reasonable accuracy, such an intangible asset may be the subject of a depreciation allowance. If the useful life is not limited, no depreciation is allowed. No allowance is permitted based upon the unsupported opinion of the taxpayer that the asset has a limited useful life.

Section 165(a) of the Code provides that there shall be allowed as a deduction any loss sustained during the taxpayer year and not compensated for by insurance or otherwise. Section 1.165-2(a) of the regulations provides that a loss incurred in a business or a transaction entered into for profit and arising from the sudden termination of the usefulness in such business or transaction of any nondepreciable property, in a case in which such business or transaction is discontinued or when such property is permanently discarded from use therein, shall be allowed as a deduction under section 165(a) for the taxable year in which the loss is actually sustained. For this purpose, the tax year in which the loss is sustained is not necessarily the tax year in which the overt act of abandonment, or the loss of title to the property, occurs.

An expenditure generally must be capitalized under section 263 of the Code if the expenditure creates, enhances, or is part of the cost of acquiring a tangible or intangible asset with a useful life greater than one year. See Commissioner v. Lincoln Savings and Loan Association, 403 U.S. 345 (1971), 1971-2 C.B. 116; Central Texas Savings and Loan Association v. United States, 731 F.2d 1181 (5th Cir. 1984); Ellis Banking Corp. v. Commissioner, 688 F.2d 1376 (11th Cir. 1982), cert. denied, 463 U.S. 1207 (1983), and Cleveland Electric Illuminating Company v. United States, 7 Cl. Ct. 220 (1985). Because package designs generally have useful lives greater than one year, package design costs generally must be capitalized under section 263. For these purposes, it is irrelevant whether a package design was created inhouse, was created by an independent contractor, or was purchased from a third party that produced it.

Advertising expenditures, which are distinguishable from package design costs, are currently deductible either because they are of a recurring nature or because their benefit does not extend beyond the tax year. See Davee v. United States, 444 F.2d 551 (Ct. Cl. 1971). In contrast, package design costs more closely resemble nonrecurring promotional or advertising expenditures that result in benefits to the taxpayer which extend beyond the year in which the expenditures are incurred; such expenditures are a capital investment and are not currently deductible. See Alabama Coca-Cola Bottling Company, T.C.M. 1969-123. See also, Cleveland Electric Illuminating Company v. United States, 7 Cl. Ct. 220 (1985), which held that advertising to lessen the public's fear of nuclear plants had to be capitalized.

X incurred certain costs in its 1986 and 1987 tax years to develop the package designs for three new products. Because these same three package designs will be used by X to generate income in its business for an indeterminate number of future years, no amortization or depreciation is allowable under section 167 of the Code and section 1.167(a)-3 of the regulations. Only when a particular package design is abandoned by X may the accumulated costs be deducted. See section 165 of the Code and section 1.165-2(a) of the regulations.

HOLDINGS

(1) Expenditures incurred by X after December 31, 1986, in connection with the development and design of its product packages must be capitalized under section 263A of the Code. X's package design expenditures incurred prior to January 1, 1987, must be capitalized pursuant to section 263 of the Code and the regulations thereunder.

(2) X's package design costs are not amortizable under section 1.167(a)-3 of the Income Tax Regulations. See, however, Rev. Proc. 89-17, page 23, this Bulletin, which allows a taxpayer to elect a deemed 60-month useful life for certain package designs.

APPLICATION

Any change in a taxpayer's method of accounting from the current expensing of package design costs to the method of capitalizing such costs described in the holding of this revenue ruling is a change in method of accounting to which sections 446 and 481 of the Code and regulations thereunder apply. See Rev. Proc. 89-16, page 18, this Bulletin, which provides additional guidance to taxpayers regarding the change in method of accounting with respect to package design costs.

This ruling is identified as a designated ruling pursuant to section 5.12(2) of Rev. Proc. 84-74, 1984-2 C.B. 736, 745.

DRAFTING INFORMATION

The principal author of this revenue ruling is Robert Testoff of the Office of Assistant Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling contact Mr. Testoff on (202) 566-4196 (not a toll-free call).