IRS Revenue Ruling
2000-4

  Code Secs. 162, 263, 263A

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26 CFR 1.162-1: Business expenses.
(Also sections 263, 263A; sections 1.263(a)-1, 1.263(a)-2, 1.263A-1)

Business expenses; capital, expenditures; ISO 9000 costs. Costs
incurred by a taxpayer to obtain, maintain, and renew ISO 9000
certification are deductible as ordinary and necessary business expenses
under section 162 of the Code, except to the extent they result in the
creation or acquisition of an asset having a useful life substantially
beyond the taxable year (e.g., a quality manual). Rev. Proc. 99-49
modified and amplified.


REV. RUL. 2000-4

ISSUE

Are costs incurred by a taxpayer to obtain, maintain, and renew ISO
9000 certification deductible as ordinary and necessary business expenses
under section 162 of the Internal Revenue Code, or must they be
capitalized under sections 263 or 263A?


FACTS

ISO 9000 is a series of international standards for quality management
systems that was developed by the International Organization for
Standardization (ISO). The ISO 9000 series of standards is comprised of
several specific requirements that are intended to ensure a quality
process in providing services or products to an organization's customers.

To obtain ISO 9000 certification, an organization may incur internal
and external costs to assess its current quality processes, create a
quality manual, train its employees, and implement the new quality system.
In addition, the organization incurs costs to obtain formal certification
from an independent auditor (or "registrar") that its quality management
system conforms to a specific ISO 9000 standard. This certification
generally lasts from two to four years. After the initial certification,
the organization incurs additional costs for periodic audits to maintain
its certification and to renew the certification upon expiration of the
initial certification period. All these expenditures are referred to
herein as "ISO 9000 costs."

Although ISO 9000 certification is voluntary, it increasingly is a
contractual requirement for doing business with many organizations, both
public and private, worldwide. ISO 9000 certification also is an
alternative to product certification in some foreign markets, particularly
the European Union.


LAW AND ANALYSIS

Section 162 and section 1.162-1(a) of the Income Tax Regulations
generally allow a deduction for all the ordinary and necessary expenses
paid or incurred during the taxable year in carrying on any trade or
business. Courts generally have construed section 162 as containing five
conditions that an expenditure must meet to qualify for deduction. The
expenditure must be (1) an expense, (2) ordinary, (3) necessary, (4) paid
or incurred during the taxable year, and (5) made to carry on a trade or
business. See Commissioner v. Lincoln Sav. and Loan Ass'n, 403 U.S. 345
(1971).

Section 263(a) and section 1.263(a)-1(a) provide that no deduction is
allowed for any amount paid out for permanent improvements or betterments
made to increase the value of any property or estate. Section
1.263(a)-2(a) provides that capital expenditures include 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 263A provides that the direct and indirect costs properly
allocable to real or tangible personal property produced by the taxpayer
or real or personal property described in section 1221(1) that is acquired
by the taxpayer for resale must be capitalized. Section
1.263A-1(e)(4)(iv)(F) cites quality control policy as an example of an
indirect cost that generally is not allocated to production or resale
activities.

Through provisions such as sections 162(a), 263(a), and 263A, the Code
generally endeavors to match expenses with the revenues of the taxable
period to which the expenses are properly attributable, thereby resulting
in a more accurate calculation of net income for tax purposes. See, e.g.,
INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); Commissioner v.
Idaho Power Co., 418 U.S. 1, 16 (1974). Moreover, as the Supreme Court has
specifically recognized, the "decisive distinctions [between capital and
ordinary expenditures] are those of degree and not of kind," and a careful
examination of the particular facts of each case is required. Deputy v.
duPont, 308 U.S. 488, 496 (1940); Welch v. Helvering, 290 U.S. 111, 114
(1933).

In determining whether a current deduction or capitalization is the
appropriate tax treatment for an expenditure, it is important to consider
the extent to which the expenditure will produce future benefits. See
INDOPCO, 503 U.S. at 87-88. ISO 9000 certification potentially results in
a number of benefits for a taxpayer. For example, certification may
improve the overall quality of the taxpayer's business operations, give
the taxpayer a marketing advantage by differentiating it from
non-certified competitors, enable the taxpayer to retain customers that
begin requiring their suppliers to be certified, and enable the taxpayer
to expand its existing business to new markets and new customers that
require their suppliers to be certified. These benefits generally both
relate to the current taxable year and extend beyond the taxable year in
which the taxpayer obtains ISO 9000 certification. Section 263(a),
however, requires an examination of not only the duration of the benefits,
but also the extent of the benefits. See INDOPCO, 503 U.S. at 87 (the mere
presence of an incidental future benefit may not warrant capitalization).
See also Rev. Rul. 96-62, 1996-2 C.B. 9 (training costs generally are
deductible under section 162 even though they may have some future
benefit); Rev. Rul. 94-12, 1994-1 C.B. 36 (incidental repair costs
generally are deductible under section 162 even though they may have some
future benefit); Rev. Rul. 92-80, 1992-2 C.B. 57 (advertising costs
generally are deductible under section 162 even though they may have some
future effect on business activities).

ISO 9000 certification does not result in future benefits that are more
than incidental. The benefits derived from ISO 9000 certification are akin
to the current benefits derived from advertising, training, and similar
expenditures incurred in operating the taxpayer's business, retaining
existing customers, or simply improving the overall quality or
attractiveness of the taxpayer's business operations. Although the
enhanced marketability of the taxpayer's services or products resulting
from ISO 9000 certification may yield future benefits such as repeat
business or increased market share, these future benefits are incidental
to the primary benefit of current sales. Expenditures that primarily
benefit current operations generally are deductible. See, e.g., Van
Iderstine Co. v. Commissioner, 261 F.2d 211 (2nd Cir. 1958) (payments made
to suppliers to ensure a continuing supply of raw materials were
deductible); Snow v. Commissioner, 31 T.C. 585 (1958), acq., 1959-2 C.B. 7
(payments made to protect and supplement the taxpayer's income from its
existing law business were deductible). See also T. J. Enterprises, Inc.
v. Commissioner, 101 T.C. 581 (1993) (expenses incurred to protect,
maintain, or preserve a taxpayer's business generally are deductible).

Further, even if ISO 9000 certification facilitates the expansion of
the taxpayer's existing business, the mere ability to sell in new markets
and to new customers, without more, does not result in significant future
benefits. Compare Briarcliff Candy Corp. v. Commissioner, 475 F.2d 775
(2nd Cir. 1973) (expenditures incurred by the taxpayer to develop a new
market for wholesale customers, which gave the taxpayer little more than
an expectation or hope of future sales, were deductible under section
162); Sun Microsystems v. Commissioner, T.C. Memo 1993-467 (costs incurred
to promote sales of computer workstations were not capital expenditures
because the anticipated long-term benefits from the customer relationship
were "softer" and more speculative than the immediate benefits from the
sales) with FMR Corp. v. Commissioner, 110 T.C. 402 (1998) (costs to
develop and launch mutual funds, which resulted in new long-term
management contracts, were capital expenditures).

Because ISO 9000 certification yields only incidental future benefits,
ISO 9000 costs are distinguishable from costs incurred to obtain licenses,
stock trading privileges, state bar certifications, and similar
market-entry requirements that have been held to be capital expenditures.
Unlike ISO 9000 certification, these requirements are an essential element
to the establishment of the taxpayer's business and result either in a
separate and distinct asset or in significant future benefits. See, e.g.,
Nachman v. Commissioner, 191 F.2d 934 (5th Cir. 1951) (payment to obtain
liquor license was a capital expenditure); Harman v. Commissioner, 72 T.C.
362 (1979) (initiation fees required to obtain a seat on the New York
Stock Exchange were capital expenditures); Sharon v. Commissioner, 66 T.C.
515 (1976), aff'd, 591 F.2d 1273 (9th Cir. 1978) (costs incurred by an
attorney for admission to various bars were capital expenditures).

Accordingly, ISO 9000 certification does not itself result in the
creation of an asset having a useful life substantially beyond the taxable
year. To the extent the ISO 9000 certification process results in the
creation of an asset, however, section 263(a) requires capitalizing the
costs allocable to creating that asset. For example, the costs of creating
a quality manual must be capitalized, even though costs of periodic
updates to the manual may be deducted. Section 263A; section
1.263A-2(a)(2)(ii), Domestic Management Bureau v. Commissioner, 38 B.T.A.
640 (1938) (costs of preparing and printing a training manual were capital
expenditures); Rev. Rul. 96-62 (costs of routine updates of training
materials are deductible). In addition, if the certification process
requires the acquisition of an asset, such as machinery and equipment, the
costs of that asset must be capitalized under section 263(a).

Further, ISO 9000 costs, other than costs incurred during the
certification process that are allocable to creating an asset such as a
quality manual, are not costs that are allocable to production or resale
activities for purposes of the uniform capitalization rules of section
263A, and thus are not subject to the rules set forth in that section or
the regulations thereunder. See section 1.263A-1(e)(4)(iv)(F) (quality
control expenditures generally excepted from uniform capitalization
rules).


HOLDING

Costs incurred by a taxpayer to obtain, maintain, and renew ISO 9000
certification are deductible as ordinary and necessary business expenses
under section 162, except to the extent they result in the creation or
acquisition of an asset having a useful life substantially beyond the
taxable year (e.g., a quality manual).


APPLICATION

Any change in a taxpayer's method of accounting to conform with this
revenue ruling is a change in method of accounting to which the provisions
of sections 446 and 481 and the regulations thereunder apply. A taxpayer
wanting to change its method of accounting to conform with the holding in
this revenue ruling must follow the automatic change in accounting method
provisions of Rev. Proc. 99-49, 1999-52 I.R.B. 725, except that the scope
limitations in section 4.02 of Rev. Proc. 99-49 do not apply. However, if
the taxpayer is under examination, before an appeals office, or before a
federal court with respect to any income tax issue, the taxpayer must
provide a copy of the Form 3115, Application for Change in Accounting
Method, to the examining agent(s), appeals officer, or counsel for the
government, as appropriate, at the same time that it files the copy of the
Form 3115 with the national office. The Form 3115 must contain the name(s)
and telephone number(s) of the examining agent(s), appeals officer, or
counsel for the government, as appropriate.


EFFECT ON OTHER DOCUMENTS

Rev. Proc. 99-49 is modified and amplified to include the prospective
change in accounting method in the APPENDIX.


DRAFTING INFORMATION

The principal author of this revenue ruling is Kimberly L. Koch of the
Office of Assistant Chief Counsel (Income Tax and Accounting). For further
information regarding this revenue ruling, contact Ms. Koch at (202)
622-4950 (not a toll-free call).

<<END RULING>>

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