[Federal Register: December 19, 2002 (Volume 67, Number 244)]
[Proposed Rules]
[Page 77701-77724]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr19de02-13]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-125638-01]
RIN 1545-BA00
Guidance Regarding Deduction and Capitalization of Expenditures
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
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SUMMARY: This document contains proposed regulations that explain how
section 263(a) of the Internal Revenue Code (Code) applies to amounts
paid to acquire, create, or enhance intangible assets. This document
also contains proposed regulations under section 167 of the Code that
provide safe harbor amortization for certain intangible assets, and
proposed regulations under section 446 of the Code that explain the
manner in which taxpayers may deduct debt issuance costs. Finally, this
document provides a notice of public hearing on these proposed
regulations.
DATES: Written or electronic comments must be received by March 19,
2003. Requests to speak and outlines of topics to be discussed at the
public hearing scheduled for April 22, 2003, must be received by April
1, 2003.
ADDRESSES: Send submissions to CC:ITA:RU (REG-125638-01), room 5226,
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington,
DC 20044. Submissions may be hand-delivered Monday through Friday
between the hours of 8 a.m. and 4 p.m. to: CC:ITA:RU (REG-125638-01),
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue,
NW., Washington, DC or sent electronically via the IRS Internet site
at: http://www.irs.gov/regs. The public hearing will be held in the IRS
Auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW.,
Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,
Andrew J. Keyso, (202) 927-9397; concerning submissions of comments,
the hearing, and/or to be placed on the building access list to attend
the hearing, Guy Traynor, (202) 622-7180 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Background
In recent years, much debate has focused on the extent to which
section 263(a) of the Code requires taxpayers to capitalize amounts
paid to acquire, create, or enhance intangible assets. On January 24,
2002, the IRS and Treasury Department published an advance notice of
proposed rulemaking (ANPRM) in the Federal Register (67 FR 3461)
announcing an intention to provide guidance in this area. The ANPRM
described and explained rules under consideration by the IRS and
Treasury Department and invited public comment on these rules.
Explanation of Provisions
I. Introduction
The proposed regulations under section 263(a) of the Code set forth
a general principle that requires capitalization of certain amounts
paid to acquire, create, or enhance intangible assets. In addition, the
proposed regulations identify specific intangible assets for which
capitalization is required under the general principle. These
identified intangible assets are grouped into categories in the
proposed regulations based on whether the intangible asset is acquired
from another party or created by the taxpayer.
The proposed regulations also provide rules for determining the
extent to which taxpayers must capitalize transaction costs that
facilitate the acquisition, creation, or enhancement of
[[Page 77702]]
intangible assets or that facilitate certain restructurings,
reorganizations, and transactions involving the acquisition of capital.
These transaction cost rules allow for the use of simplifying
conventions intended to promote administrability and reduce the cost of
compliance with section 263(a). In addition, the proposed regulations
under section 167 of the Code provide a safe harbor amortization period
applicable to certain created intangible assets that do not have
readily ascertainable useful lives and for which an amortization period
is not otherwise prescribed or prohibited by the Code, regulations, or
other published guidance.
As a general rule, the proposed regulations are not intended to
apply to a taxpayer's intangible interest in land. Thus, the proposed
regulations do not apply to amounts paid to acquire or create
easements, life estates, mineral interests, timber rights, or other
intangible interests in land. An exception is made for amounts paid to
acquire, create, or enhance a lease of real property. Several rules
contained in the proposed regulations address amounts paid to acquire,
create, or enhance leases of property, including leases of real
property. The IRS and Treasury Department are considering future
guidance addressing the treatment of amounts paid to acquire, create,
or enhance tangible assets. Appropriate rules relating to the treatment
of interests in land will be addressed in that future guidance.
II. General Principle of Capitalization
A. Overview
The proposed regulations require capitalization of amounts paid to
acquire, create, or enhance an intangible asset. For this purpose, an
intangible asset is defined as (1) any intangible that is acquired from
another person in a purchase or similar transaction (as described in
paragraph (c) of the proposed regulations); (2) certain rights,
privileges, or benefits that are created or originated by the taxpayer
and identified in paragraph (d) of the proposed regulations; (3) a
separate and distinct intangible asset (as defined in paragraph (b)(3)
of the proposed regulations); or (4) a future benefit that the IRS and
Treasury Department identify in subsequent published guidance as an
intangible asset for which capitalization is required. As discussed in
Part V of this preamble, the proposed regulations also require
capitalization of transaction costs that facilitate the acquisition,
creation, or enhancement of an intangible asset or that facilitate a
restructuring or reorganization of a business entity or a transaction
involving the acquisition of capital, such as a stock issuance,
borrowing, or recapitalization.
Through this definition of intangible asset, the IRS and Treasury
Department seek to provide certainty for taxpayers by identifying
specific categories of rights, privileges, and benefits, the costs of
which are appropriately capitalized. In determining the categories of
expenditures for which capitalization is specifically required, the IRS
and Treasury Department considered expenditures for which the courts
have traditionally required capitalization. These categories will help
promote consistent interpretation of section 263(a) by taxpayers and
IRS field personnel.
B. Separate and Distinct Intangible Asset
The proposed regulations define the term separate and distinct
intangible asset based on factors traditionally used by the courts to
determine whether an expenditure serves to acquire, create, or enhance
a separate and distinct asset. Courts have considered (1) whether the
expenditure creates a distinct and recognized property interest subject
to protection under state or federal law; (2) whether the expenditure
creates anything transferrable or salable; and (3) whether the
expenditure creates anything with an ascertainable and measurable value
in money's worth. See, e.g., Commissioner v. Lincoln Savings & Loan
Ass'n, 403 U.S. 345, 355 (1971); Central Texas Savings & Loan Ass'n v.
United States, 731 F.2d 1181, 1184 (5th Cir. 1984); Colorado Springs
National Bank v. United States, 505 F.2d 1185, 1192 (10th Cir. 1974);
Briarcliff Candy Corp. v. Commissioner, 475 F.2d 775, 784 (2nd Cir.
1973).
The proposed regulations provide that the determination of whether
an amount serves to acquire, create, or enhance a separate and distinct
intangible asset is made as of the taxable year during which the amount
is paid, and not later using the benefit of hindsight.
The IRS and Treasury Department note that the separate and distinct
asset standard has not historically yielded the same level of
controversy as the significant future benefit standard. Moreover,
several commentators suggested that, if the proposed regulations adopt
a general principle of capitalization, the separate and distinct asset
test is a workable principle in practice.
C. Significant Future Benefits Identified in Published Guidance
A fundamental purpose of section 263(a) is to prevent the
distortion of taxable income through current deduction of expenditures
relating to the production of income in future years. Thus, in
determining whether an expenditure should be capitalized, the Supreme
Court has considered whether the expenditure produces a significant
future benefit. INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992). A
``significant future benefit'' standard, however, does not provide the
certainty and clarity necessary for compliance with, and sound
administration of, the law. Consequently, the IRS and Treasury
Department believe that simply restating the significant future benefit
test, without more, would lead to continued uncertainty on the part of
taxpayers and continued controversy between taxpayers and the IRS.
Accordingly, the IRS and Treasury Department have initially defined the
exclusive scope of the significant future benefit test through the
specific categories of intangible assets for which capitalization is
required in the proposed regulations. The future benefit standard
underlies many of these categories.
The IRS and Treasury Department recognize, however, that there may
be expenditures that are not identified in these categories, but for
which capitalization is nonetheless appropriate. For this reason, the
proposed regulations require capitalization of non-listed expenditures
if those expenditures serve to produce future benefits that the IRS and
Treasury Department identify in published guidance as significant
enough to warrant capitalization. A determination in published guidance
that a particular category of expenditure produces a benefit for which
capitalization is appropriate will apply prospectively, and will not
apply to expenditures incurred prior to the publication of such
guidance.
For purposes of future guidance, the IRS and Treasury Department
will determine whether capitalization is appropriate for a particular
category of expenditures by taking into account all relevant facts and
circumstances, including the probability, measurability, and size of
the expected future benefit. Such published guidance may provide a safe
harbor amortization period for any expenditure required to be
capitalized. If the published guidance does not provide a safe harbor
amortization period, the expenditure may be eligible for the 15-year
safe harbor amortization
[[Page 77703]]
period described in Part VII.A. of this preamble.
The IRS and Treasury Department believe that, by applying the
significant future benefit test in the manner described above, the
proposed regulations will substantially reduce the burden on both
taxpayers and IRS field personnel of determining whether an expenditure
produces significant future benefits for which capitalization is
required. If an expenditure is not described in one of the categories
in the proposed regulations or in subsequent future guidance, taxpayers
and IRS field personnel need not determine whether that expenditure
produces a significant future benefit. Upon finalization of the
proposed regulations, the IRS expects to identify and withdraw existing
capitalization guidance that is susceptible to application inconsistent
with these regulations.
III. Intangibles Acquired From Another
Paragraph (c) of the proposed regulations requires capitalization
of amounts paid to another party to acquire an intangible from that
party in a purchase or similar transaction. This rule reflects well-
settled law requiring capitalization of the purchase price (including
sales taxes and similar charges) paid to acquire property from another.
The regulations provide examples of intangibles that must be
capitalized under this rule if the intangible is acquired from another
person. Many of the intangibles required to be capitalized by this rule
constitute ``amortizable section 197 intangibles'' eligible for 15-year
amortization under section 197(a).
The rule does not address the treatment of any transaction costs
the taxpayer may incur to facilitate the acquisition of an intangible
from another party. The treatment of transaction costs is described in
paragraph (e) of the proposed regulations. So, for example, while this
rule requires capitalization of the amount paid to another party to
acquire an intangible from that party, this rule does not describe the
treatment of the various ancillary costs such as attorney fees and
broker commissions incurred to facilitate the acquisition.
In addition, the rule applies only to acquired intangibles, and not
to created intangibles. For example, the rule requires a taxpayer to
capitalize the amount paid to acquire a customer base from another
person. However, the rule does not require a taxpayer to capitalize
costs that it incurs to create its own customer base.
IV. Created Intangibles
Paragraph (d) of the proposed regulations requires taxpayers to
capitalize amounts paid to another party to create or enhance with that
party certain identified intangibles discussed in Parts IV.A. through
IV.H. of this preamble. Examples are included to demonstrate the scope
of these rules.
To reduce the administrative and compliance costs associated with
capitalizing these amounts, the proposed regulations adopt a ``12-month
rule'' applicable to most created intangibles. Under this 12-month
rule, a taxpayer is not required to capitalize amounts that provide
benefits of a relatively brief duration. The 12-month rule is discussed
in further detail in Part VI of this preamble.
As in the case of acquired intangibles, the rules in paragraph (d)
relating to created intangibles address the amounts paid for the
intangible itself, and not the related transaction costs incurred to
facilitate the creation of the intangible. The treatment of transaction
costs is described in paragraph (e) of the proposed regulations.
A. Financial Interests
The proposed regulations require taxpayers to capitalize amounts
paid to another party to create or originate with that party certain
financial interests. The financial interests identified in the rule
include interests in entities (e.g., corporations, partnerships,
trusts) and financial instruments (e.g., debt instruments, notional
principal contracts, options).
The 12-month rule does not apply to amounts paid to create or
enhance a financial interest described in this rule, regardless of
whether the amounts are also described in another part of paragraph (d)
of the proposed regulations.
B. Prepaid Expenses
In general, existing law requires capitalization of prepaid
expenses. See, e.g., Commissioner v. Boylston Market Ass'n, 131 F.2d
966 (1st Cir. 1942). The proposed regulations require capitalization of
amounts prepaid for benefits to be received in the future. The proposed
regulations modify slightly the rule contained in the ANPRM, which
proposed capitalization of ``amounts prepaid for goods, services, or
other benefits (such as insurance) to be received in the future.'' The
reference to ``goods'' in the ANPRM caused some readers to question
whether the proposed rule is intended to apply to the acquisition of
tangible property. The rule is not intended to apply to the acquisition
of tangible property. The rule proposes capitalization of prepaid
expenses on the ground that the prepayment creates an intangible asset
in the form of a right; specifically, the right to receive goods,
services, or other benefits in the future. The IRS and Treasury
Department decided to eliminate further confusion by modifying the rule
to remove the explicit reference to goods.
Further, the reference in the rule to ``benefits to be received in
the future'' is not intended to imply a form of ``significant future
benefit'' test applicable to any expenditure that can be expected to
result in some future benefit. As demonstrated by examples in the
proposed regulations, the rule is intended merely to require
capitalization of prepaid expenses.
C. Amounts Paid To Obtain Certain Memberships and Privileges
The proposed regulations require taxpayers to capitalize amounts
paid to an organization to obtain or renew a membership or privilege
from that organization. The rule clarifies that amounts paid to obtain
a quality certification of the taxpayer's products, services, or
business processes are not within the scope of the rule. Thus, for
example, the rule does not require capitalization of amounts paid to
obtain benefits such as ISO 9000 certification or Underwriters'
Laboratories Listing.
D. Amounts Paid To Obtain Certain Rights From a Governmental Agency
The proposed regulations require taxpayers to capitalize amounts
paid to a governmental agency for a trademark, trade name, copyright,
license, permit, franchise, or other similar right granted by that
governmental agency. In general, this rule is directed at the initial
fee paid to a government agency. Under the 12-month rule, taxpayers are
not required to capitalize annual renewal fees paid to the government
agency. An example in the proposed regulations demonstrates this point.
These regulations do not affect the treatment of expenditures under
other provisions of the Code. Accordingly, an amount paid to a
government agency to obtain a patent from that agency is not required
to be capitalized under this section if the amount is deductible under
section 174.
E. Amounts Paid To Obtain or Modify Contract Rights
The proposed regulations require taxpayers to capitalize amounts
(other than de minimis amounts) paid to another party to induce that
party to enter into, renew, or renegotiate an
[[Page 77704]]
agreement that produces certain rights for the taxpayer. This rule
recognizes that some agreements produce contract rights that are
reasonably certain to produce future benefits for the taxpayer, or for
which courts have traditionally required capitalization. For example,
the rule requires capitalization of amounts paid to enter into or
renegotiate a lease contract or a contract providing the taxpayer the
right to acquire or provide services. The rule also requires
capitalization of an amount paid to obtain a covenant not to compete.
Recognizing that employment contracts often are entered into along with
covenants not to compete, the proposed regulations contain a rule
similar to that in Sec. 1.197-2(b)(9) of the regulations. An agreement
for the performance of services does not have substantially the same
effect as a covenant not to compete and, accordingly, amounts paid for
personal services actually rendered are not required to be capitalized
under this rule.
On the other hand, the rule recognizes that many agreements do not
produce contract rights for which capitalization is appropriate. Thus,
the rule does not require a taxpayer to capitalize an amount that
merely creates an expectation that a customer or supplier will maintain
its business relationship with the taxpayer.
The rule contains a de minimis exception under which inducements
that do not exceed $5,000 are not required to be capitalized. The IRS
and Treasury Department request comments on whether a non-cash
inducement is properly valued at the taxpayer's cost to acquire or
produce the inducement, or at the fair market value of the inducement.
If the non-cash inducement is properly valued at its fair market value,
comments are requested regarding the treatment of any gain or loss
realized on the transfer of the non-cash inducement.
This rule and the financial interests rule (described in Part IV.A.
of this preamble) are the exclusive capitalization provisions for
created contracts. In other words, amounts paid to enter into an
agreement not identified in these rules are not required to be
capitalized under the general principle of capitalization on the theory
that the agreement is a separate and distinct asset.
F. Amounts Paid To Terminate Certain Contracts
The proposed regulations require taxpayers to capitalize an amount
paid to terminate three types of contracts. The purpose of the rule is
to require capitalization of termination payments that enable the
taxpayer to reacquire some valuable right it did not possess
immediately prior to the termination. Thus, capitalization is required
for payments by a lessor to terminate a lease agreement with a lessee.
See Peerless Weighing and Vending Machine Corp. v. Commissioner, 52
T.C. 850 (1969). Capitalization also is required for payments by a
taxpayer to terminate an agreement that provides another party the
exclusive right to acquire or use the taxpayer's property or services
or to conduct the taxpayer's business. See Rodeway Inns of America v.
Commissioner, 63 T.C. 414 (1974). Finally, capitalization is required
for payments to terminate an agreement that prohibits the taxpayer from
competing with another or from acquiring property or services from a
competitor of another.
On the other hand, the rule does not require capitalization in
cases where the taxpayer, as a result of the termination, does not
reacquire a right for which capitalization is appropriate. For example,
the rule does not require a taxpayer to capitalize a payment to
terminate a supply contract with a supplier, and does not require a
lessee to capitalize a payment to terminate a lease agreement with a
lessor. This also is consistent with existing law. See, e.g., Stuart
Co. v. Commissioner, 195 F.2d 176 (9th Cir. 1952), aff'g 9 T.C.M. (CCH)
585 (1950); Olympia Harbor Lumber Co. v. Commissioner, 30 B.T.A. 114
(1934), aff'd, 79 F.2d 394 (9th Cir. 1935); Denholm & McKay Co. v.
Commissioner, 2 B.T.A. 444 (1925); Rev. Rul. 69-511 (1969-2 C.B. 24).
The proposed regulations modify, in several respects, the rule
described in the ANPRM. First, the proposed regulations expand the rule
to require capitalization of an amount paid to terminate a contract
that grants another the exclusive right to acquire or use the
taxpayer's property or services. Thus, a taxpayer must capitalize
amounts paid to terminate an exclusive license to use the taxpayer's
property. Second, the proposed regulations remove the reference to a
defined geographic area from the rule requiring capitalization of
amounts paid to terminate an agreement that provides another party the
exclusive right to conduct the taxpayer's business. The IRS and
Treasury Department are concerned that this reference may lead to
uncertainty regarding whether the parties intended for a particular
right to be limited to a defined geographic area, especially where the
agreement is silent regarding geographic area. Third, as discussed
above, the proposed regulations require a taxpayer to capitalize an
amount paid to another to terminate an agreement that prohibits the
taxpayer from competing with another.
G. Amounts Paid To Acquire, Produce, or Improve Real Property Owned by
Another
The proposed regulations require taxpayers to capitalize an amount
paid to acquire real property that is relinquished to another, or to
produce or improve real property that is owned by another, if the real
property is reasonably expected to produce significant economic
benefits for the taxpayer. The purpose of this rule is to recognize a
long line of cases and rulings that require capitalization where the
taxpayer provides property to another or improves property of another
with the expectation that the property will provide significant future
benefits for the taxpayer. See D. Loveman & Son Export Corp. v.
Commissioner, 34 T.C. 776 (1960), aff'd 296 F.2d 732 (6th Cir. 1961)
(expenditures incurred by the taxpayer to pave a public road benefitted
the taxpayer's business and were appropriately capitalized); Chicago
and N.W. Railway Co. v. Commissioner, 39 B.T.A. 661 (1939) (conveyance
of land by a railroad to a city for highway purposes, the effect of
which is of lasting benefit by way of flood protection, access to city
streets, and reduced cost of crossing protection is a capital
expenditure); Kauai Terminal Ltd. v. Commissioner, 36 B.T.A. 893 (1937)
(expenditures incurred by the taxpayer to construct a publicly owned
breakwater for the purpose of improving the taxpayer's freight
lighterage operation are capital expenditures); Rev. Rul. 69-229 (1969-
1 C.B. 86) (expenditures incurred by a railroad company for
construction of a state-owned highway bridge over its tracks create a
long term business benefit for the taxpayer and are therefore capital
expenditures); Rev. Rul. 66-71 (1966-1 C.B. 44) (expenditures incurred
by the taxpayer for dredging to deepen the portion of a harbor
alongside the taxpayer's pier leading to a navigable channel are
capital expenditures).
The proposed regulations limit the scope of the rule to real
property, and not to all tangible property as originally contemplated
by the ANPRM. Some courts have required capitalization on the ground
that an intangible asset is created where the taxpayer provides
tangible personal property to another. See, e.g., Alabama Coca-Cola
Bottling Co. v. Commissioner, T.C. Memo. 1969-123 (capitalization
required for costs incurred by a wholesaler to provide signs,
scoreboards, and clocks bearing
[[Page 77705]]
its product logo to retail outlets; the expenditure created valuable
benefits that would benefit the taxpayer beyond the taxable year).
Nonetheless, the IRS and Treasury Department are reluctant to extend
the rule to cases involving tangible personal property. Inclusion of
personal property within the scope of the rule would require
capitalization of many expenditures that are properly deductible under
current law, such as advertising or business promotion costs.
The proposed regulations clarify that the rule is not intended to
apply where the taxpayer is selling the real property, is providing the
real property to another as payment for some other property or service
provided to the taxpayer, or is selling services to produce or improve
the property. The proposed regulations also clarify that the rule is
not intended to change the result in Rev. Rul. 2002-9 (2002-10 I.R.B.
614), regarding the treatment of impact fees paid by a developer of
real property. Rev. Rul. 2002-9 provides that impact fees incurred by a
taxpayer in connection with the construction of real property are
capitalized costs allocable to the real property. The proposed
regulations provide that these costs do not create an intangible asset
for which capitalization is required by this rule. Similarly, the
proposed regulations provide that real property turned over to a
government entity in connection with a real estate development project
(dedicated improvements) also are outside the scope of this rule. Such
costs are allocable to the property produced, as provided in section
263A and the regulations thereunder.
For costs required to be capitalized under this rule, the proposed
regulations under section 167 permit safe harbor amortization ratably
over a 25-year period. The IRS and Treasury Department did not adopt
the approach suggested by commentators of permitting amortization over
the recovery period prescribed for the property under section 168 as if
the taxpayer had actually owned the real property and used it in its
trade or business. The IRS and Treasury Department believe that such an
approach would raise difficult questions regarding the appropriate
class life or recovery period to be applied. In addition, such an
approach would not address the treatment of property for which a class
life or recovery period is not prescribed by section 168, such as
vacant land. The 25-year safe harbor will eliminate the uncertainty
that would otherwise exist if amortization were permitted over the
period of the expected future benefit. The IRS and Treasury Department
invite comments on this safe harbor amortization provision.
H. Amounts Paid To Defend or Perfect Title to Intangible Property
The proposed regulations require taxpayers to capitalize an amount
paid to another party to defend or perfect title to intangible property
where the other party challenges the taxpayer's title to the intangible
property. This is consistent with existing regulations under section
263(a) of the Code. See Sec. 1.263(a)-2(c). The rule is not intended
to require capitalization of amounts paid to protect the property
against infringement and to recover profits and damages as a result of
an infringement. As under current law, these costs are generally
deductible. See, e.g., Urquhart v. Commissioner, 215 F.2d 17 (3rd Cir.
1954) (expenditures made by a licensor of patents to protect against
infringement and to recover profits and damages were made to protect,
conserve, and maintain business profits, and not to defend or perfect
title to property). Whether an amount is paid to defend or perfect
title, on the one hand, or to protect against infringement, on the
other, is a factual matter.
V. Transaction Costs
A. In General
The proposed regulations provide a two-pronged rule that requires
taxpayers to capitalize transaction costs. The first prong of the rule
requires capitalization of transaction costs that facilitate the
taxpayer's acquisition, creation, or enhancement of an intangible
asset. The second prong of the rule requires capitalization of
transaction costs that facilitate the taxpayer's restructuring or
reorganization of a business entity or facilitate a transaction
involving the acquisition of capital, including a stock issuance,
borrowing, or recapitalization.
The first prong of the transaction cost rule recognizes that
capitalization is required not only for the cost of an asset itself,
but for the ancillary expenditures incurred in acquiring, creating, or
enhancing the intangible asset. Woodward v. Commissioner, 397 U.S. 572
(1970). The proposed regulations require that taxpayers capitalize
these transaction costs to the basis of the intangible asset acquired,
created, or enhanced.
The second prong of the transaction cost rule recognizes that
transaction costs that effect a change in the taxpayer's capital
structure create betterments of a permanent or indefinite nature and
are appropriately capitalized. See INDOPCO, Inc. v. Commissioner, 503
U.S. 79 (1992) (professional fees incurred by a target corporation in a
stock acquisition); General Bancshares Corp. v. Commissioner, 326 F.2d
712 (8th Cir. 1964) (costs to issue a stock dividend to shareholders);
Mills Estate, Inc. v. Commissioner, 206 F.2d 244 (2nd Cir. 1953)
(professional fees incurred in a recapitalization). As discussed in
further detail in Part VII of this preamble (relating to safe harbor
amortization), the proposed regulations do not address whether these
costs increase the taxpayer's basis in property or are treated as a
separate intangible asset. Comments are requested on these issues.
However, in the case of transaction costs that facilitate a stock
issuance or recapitalization, the proposed regulations are consistent
with existing law, which provides that such capital expenditures do not
create a separate intangible asset, but instead offset the proceeds of
the stock issuance. See Rev. Rul. 69-330 (1969-1 C.B. 51); Affiliated
Capital Corp. v. Commissioner, 88 T.C. 1157 (1987). The proposed
regulations provide that capitalization is not required under this
provision for stock issuance costs of open-end regulated investment
companies (other than those costs incurred during the initial stock
offering period). See Rev. Rul. 94-70 (1994-2 C.B. 17).
As discussed in Part VII of this preamble, costs required to be
capitalized under the second prong of the transaction cost rule are not
eligible for the safe harbor amortization provision provided in the
regulations. However, comments are requested on whether the safe harbor
amortization provision should apply to any of these costs.
The term reorganization as used in the second prong of the
transaction cost rule contemplates a reorganization in the broad sense
of a change to an entity's capital structure, and not merely a
transaction that constitutes a tax-free reorganization under the Code.
The terms reorganization and restructuring are broad enough to include
transactions under section 351 of the Code, as well as bankruptcy
reorganizations. While the term is broad enough to encompass stock
redemptions, the treatment of costs incurred in connection with a stock
redemption is specifically prescribed by section 162(k). The terms
reorganization and restructuring are not intended to refer to mere
changes in an entity's business processes, commonly referred to as
``re-engineering.'' Thus, a taxpayer's change from a batch inventory
processing system to a ``just-in-time'' inventory processing system,
[[Page 77706]]
regardless of whether the taxpayer refers to such change as a business
``restructuring,'' is not within the scope of the rule, as demonstrated
by example in the proposed regulations.
Consistent with existing law, the rule requires capitalization of
costs to facilitate a divisive transaction. See Bilar Tool & Dye Corp.
v. Commissioner, 530 F.2d 708 (6th Cir. 1976). However, the rule does
not require capitalization of amounts paid to facilitate a divisive
transaction where the divestiture is pursuant to a government mandate,
unless the divestiture is a condition of permitting the taxpayer to
participate in a separate restructuring or reorganization transaction.
See, e.g., El Paso Co. v. United States, 694 F.2d 703 (Fed Cir. 1982);
American Stores Co. v. Commissioner, 114 T.C. 458 (2000).
In the ANPRM, the second prong of the transaction cost rule applied
to ``an applicable asset acquisition within the meaning of section
1060(c).'' This language caused confusion as to whether the second
prong of the transaction cost rule applied to acquisitions of tangible
assets. To clarify that the transaction cost rules do not apply to
acquisitions of tangible assets (other than acquisitions of real
property described in Part IV.G. of this preamble) the proposed
regulations delete the reference to section 1060(c). To the extent that
intangible assets are acquired in an applicable asset acquisition under
section 1060(c), the first prong of the transaction cost rule requires
capitalization of transaction costs that facilitate the acquisition of
those intangible assets. Transaction costs allocable to tangible assets
are capitalized to the extent provided by existing law. The IRS and
Treasury Department are considering separate guidance to address the
treatment of expenditures to acquire, create, or enhance tangible
assets.
B. Facilitate
The proposed regulations provide a ``facilitate'' standard for
purposes of determining whether transaction costs must be capitalized.
The facilitate standard is intended to be narrower in scope than a
``but-for'' standard. Thus, some transaction costs that arguably are
capital under a but-for standard, such as costs to downsize a workforce
after a corporate merger (including severance payments) or costs to
integrate the operations of merged businesses, are not required to be
capitalized under a facilitate standard. While such costs may not have
been incurred but-for the merger, the costs do not facilitate the
merger itself. The proposed regulations provide that an amount
facilitates a transaction if it is incurred in the process of pursuing
the acquisition, creation, or enhancement of an intangible asset or in
the process of pursuing a restructuring, reorganization, or transaction
involving the acquisition of capital.
In response to the ANPRM, commentators suggested that the proposed
regulations should distinguish costs to facilitate the acquisition of a
trade or business from costs to investigate the acquisition of a trade
or business. Several commentators suggested that the proposed
regulations should adopt the standard contained in Rev. Rul. 99-23
(1999-1 C. B. 998).
Rev. Rul. 99-23 provides a ``whether-and-which'' test for
distinguishing costs to investigate the acquisition of a new trade or
business (which are amortizable under section 195) from costs to
facilitate the acquisition (which are capital expenditures under
section 263(a) and are not amortizable under section 195). Under this
test, costs incurred to determine whether to acquire a new trade or
business, and which new trade or business to acquire, are investigatory
costs. Costs incurred in the attempt to acquire a specific business are
costs to facilitate the consummation of the acquisition.
Because Rev. Rul. 99-23 has created controversy between taxpayers
and the IRS, the proposed regulations do not adopt the standard
contained in Rev. Rul. 99-23. Rather, the proposed regulations provide,
as a bright line rule, that an amount paid in the process of pursuing
an acquisition of a trade or business (whether the acquisition is
structured as an acquisition of stock or of assets and whether the
taxpayer is the acquirer in the acquisition or the target of the
acquisition) is required to be capitalized only if the amount is
``inherently facilitative'' or if the amount relates to activities
performed after the earlier of the date a letter of intent (or similar
communication) is issued or the date the taxpayer's Board of Directors
approves the acquisition proposal. For this purpose, the proposed
regulations identify amounts that are inherently facilitative (e.g.,
amounts relating to determining the value of the target, drafting
transactional documents, or conveying property between the parties).
Under this bright line rule, an amount that does not facilitate the
acquisition is not required to be capitalized under this section. The
proposed regulations do not affect the treatment of start-up
expenditures under section 195. The IRS and Treasury Department are
considering the application of these bright line standards to tangible
assets acquired as part of a trade or business in order to provide a
single administrable standard in these transactions. The IRS and
Treasury Department request comments on whether the bright line
standard provided in the proposed regulations is administrable and
whether there are other bright line standards that can be applied in
this area.
The proposed regulations provide that a success-based fee is an
amount paid to facilitate the acquisition except to the extent that
evidence clearly demonstrates that some portion of the amount is
allocable to activities that do not facilitate the acquisition. The IRS
and Treasury Department request comments on the treatment of success-
based fees.
The IRS and Treasury Department stress that section 6001 of the
Code requires taxpayers to maintain sufficient records to support a
position claimed on the taxpayer's return. Thus, taxpayers must
maintain records adequate to document that amounts relate to activities
performed prior to the bright line date. Comments are requested on the
types of records that are available in the context of an acquisition of
a trade or business and how these records might be utilized to
administer the bright line rule.
C. Hostile Takeover Defense Costs
The proposed regulations provide that transaction costs incurred by
a taxpayer to defend against a hostile takeover of the taxpayer's stock
do not facilitate the acquisition and therefore are not required to be
capitalized. See A.E. Staley Mfg. Co. v. Commissioner, 119 F.3d 482
(7th Cir. 1997). The proposed regulations recognize, however, that an
initially hostile acquisition attempt may eventually become friendly.
In such a case, the rules require the taxpayer to bifurcate its costs
between those incurred to defend against the acquisition attempt at the
time the attempt was hostile and those incurred to facilitate the
friendly acquisition. Capitalization is required for costs incurred to
facilitate the friendly acquisition. The IRS and Treasury Department
request comments on rules that might be applied to determine the point
at which a hostile acquisition attempt becomes friendly.
Some costs may be viewed both as costs to defend against a hostile
acquisition and as costs to facilitate another capital transaction. For
example, a taxpayer may attempt to thwart a hostile acquisition by
merging with a white knight, recapitalizing, or issuing stock purchase
rights to existing shareholders. The proposed regulations require
capitalization of such costs,
[[Page 77707]]
regardless of whether the taxpayer's purpose in incurring such costs
was solely to defend against a hostile acquisition.
D. Simplifying Conventions Applicable to Transaction Costs
1. Salaries and Overhead
Much of the recent debate surrounding section 263(a) has focused on
the extent to which capitalization is required for employee
compensation and overhead costs that are related to the acquisition,
creation, or enhancement of an asset. Generally, courts and the Service
have required capitalization of such costs where the facts show that
the costs clearly are allocable to a particular asset. See Commissioner
v. Idaho Power Co., 418 U.S. 1 (1973) (requiring capitalization of
depreciation on equipment used to construct capital assets and noting
that wages, when paid in connection with the construction or
acquisition of a capital asset, must be capitalized and amortized over
the life of the capital asset); Louisville and N.R. Co. v.
Commissioner, 641 F.2d 435 (6th Cir. 1981) (requiring capitalization of
overhead costs associated with building and rebuilding railroad freight
cars); Lychuk v. Commissioner, 116 T.C. 374 (2001) (requiring
capitalization of employee compensation where employees spent a
significant portion of their time working on acquisitions of
installment obligations); Rev. Rul. 73-580 (1973-2 C.B. 86) (requiring
capitalization of employee compensation reasonably attributable to
services performed in connection with corporate mergers and
acquisitions).
In the context of intangible assets, some courts have allowed
taxpayers to deduct employee compensation and overhead where there is
only an indirect nexus between the intangible asset and the
compensation or overhead. See Wells Fargo v. Commissioner, 224 F.3d 874
(8th Cir. 2000) (deduction allowed for officers' salaries allocable to
work performed by corporate officers in negotiating a merger
transaction because the salaries ``originated from the employment
relationship between the taxpayer and its officers'' and not from the
merger transaction); PNC Bancorp v. Commissioner, 212 F.3d 822 (3rd
Cir. 2000) (deduction allowed for compensation and other costs of
originating loans to borrowers); Lychuk v. Commissioner, 116 T.C. 374
(2001) (capitalization not required for overhead costs allocable to the
taxpayer's acquisition of installment loans because the overhead did
not originate in the process of acquiring the installment notes, and
would have been incurred even if the taxpayer did not engage in such
acquisition).
To resolve much of this controversy, and to eliminate the burden on
taxpayers of allocating certain transaction costs among various
intangible assets, the proposed regulations provide a simplifying
assumption that employee compensation and overhead costs do not
facilitate the acquisition, creation or enhancement of an intangible
asset. The rule applies regardless of the percentage of the employee's
time that is allocable to capital transactions. For example,
capitalization is not required for compensation paid to an employee of
the taxpayer who works full time on merger transactions.
The proposed regulations modify the rule proposed in the ANPRM by
extending the scope of the rule to all employee compensation, whether
paid in the form of salary, bonus, or commission. Commentators noted
that bonuses are rarely paid with respect to one particular
transaction, and a requirement to capitalize bonuses would not result
in simplification given the necessity of allocating bonuses among
capital transactions. In the case of overhead, the proposed regulations
modify the rule proposed in the ANPRM by extending the scope of the
rule to variable overhead. The IRS and Treasury Department have
concluded that the clearer reflection of income that might be gained by
requiring capitalization of employee compensation and overhead does not
offset the administrative and record keeping burdens imposed by a
capitalization requirement.
These simplifying conventions are intended to be rules of
administrative convenience, and not substantive rules of law.
Accordingly, in the case of employee compensation and overhead, the IRS
and Treasury Department are considering limiting the application of the
simplifying conventions to taxpayers that deduct these costs for
financial accounting purposes. Under this approach, the simplifying
conventions for employee compensation and overhead would not apply to
taxpayers that capitalize these costs for financial accounting
purposes. A book-tax conformity rule would recognize that there is no
simplification gained by allowing a deduction for employee compensation
and overhead where the taxpayer allocates these costs to intangible
assets and capitalizes them for financial accounting purposes. The IRS
and Treasury Department anticipate that any such book-tax conformity
rule would not apply to de minimis costs.
The proposed regulations do not presently include a book-tax
conformity rule. However, the IRS and Treasury Department request
comments on whether the final regulations should apply a book-tax
conformity rule to employee compensation and overhead.
2. De Minimis Costs
The proposed regulations provide that de minimis transaction costs
do not facilitate a capital transaction and therefore are not required
to be capitalized. The rule defines de minimis costs as costs that do
not exceed $5,000. The IRS and Treasury Department considered whether
the de minimis rule should be based on the taxpayer's gross receipts,
total assets, or some other variable benchmark, rather than a fixed
amount. The IRS and Treasury Department decided not to adopt such an
approach because of concern that it would add complexity and create
administrability issues, particularly where the benchmark amount
changes as a result of amended returns or audit adjustments.
The proposed regulations clarify that the de minimis rule applies
on a transaction-by-transaction basis. As demonstrated by examples in
the proposed regulations, a single transaction may involve the
acquisition of multiple intangible assets. The proposed regulations
also clarify that if transaction costs (other than compensation and
overhead) exceed $5,000, no portion of the costs is considered de
minimis under the rule. Thus, all of the costs (not just the cost in
excess of $5,000) must be capitalized. The IRS and Treasury Department
request comments on whether additional rules are required to prevent
taxpayers from improperly fragmenting agreements or transactions to
take advantage of the de minimis rules contained in the proposed
regulations.
The proposed regulations contain rules for aggregating costs
allocable to a transaction. While taxpayers generally must account for
the actual costs allocable to each transaction, the proposed
regulations permit taxpayers to determine the applicability of the de
minimis rules by computing the average transaction cost for a pool of
similar transactions. The IRS and Treasury Department recognize that
this average cost pooling method could result in a skewed average cost
where several unusually large transactions occur during the year and
request comments on how to address such transactions. If the final
regulations ultimately provide this pooling mechanism for computing
average transaction costs, taxpayers are reminded of their obligations
under
[[Page 77708]]
section 6001 of the Code to maintain such records as are sufficient to
establish the amount of any deductions claimed as de minimis costs.
The proposed regulations provide that the de minimis rule does not
apply to commissions paid to acquire or create certain financial
interests. Accordingly, taxpayers must capitalize such commissions. The
IRS and Treasury Department note that the treatment of commissions is
well-settled under existing law. See Helvering v. Winmill, 305 U.S. 79
(1938); Sec. 1.263(a)-2(e). In addition, because commissions generally
are traceable to a particular acquisition or creation, no
simplification is gained by treating commissions as de minimis costs.
3. Regular and Recurring Costs
The ANPRM requested public comment on whether the recurring or
nonrecurring nature of a transaction is an appropriate consideration in
determining whether an expenditure incurred to facilitate a transaction
must be capitalized under section 263(a) and, if so, what criteria
should be applied in distinguishing between recurring and nonrecurring
transactions. The IRS and Treasury Department considered the public
comments and concluded that a regular and recurring rule would likely
be too vague to be administrable. The IRS and Treasury Department
believe that the simplifying conventions for employee compensation,
overhead, and de minimis costs address the types of regular and
recurring costs that are most appropriately excluded from
capitalization. Thus, a regular and recurring rule is not provided in
the proposed regulations.
VI. 12-Month Rule
A. In General
The existing regulations under sections 263(a), 446, and 461
require taxpayers to capitalize expenditures that create an asset
having a useful life substantially beyond the close of the taxable
year. See Sec. Sec. 1.263(a)-2(a), 1.446-1(c)(1)(ii), and 1.461-
1(a)(2)(i). In determining whether an asset has a useful life
substantially beyond the close of the taxable year, some courts have
adopted a ``one-year'' rule. U.S. Freightways Corp. v. Commissioner,
270 F.3d 1137 (7th Cir. 2001), rev'g 113 T.C. 329 (1999); Zaninovich v.
Commissioner, 616 F.2d 429 (9th Cir. 1980). Under this rule, an
expenditure may be deducted in the year it is incurred, as long as the
benefit resulting from the expenditure does not have a useful life that
extends beyond one year.
The IRS and Treasury Department think that a ``12-month'' rule
would help to reduce the administrative and compliance costs inherent
in applying section 263(a) to amounts paid to create or enhance
intangible assets. Accordingly, under the proposed regulations, certain
amounts (including transaction costs) paid to create or enhance
intangible rights or benefits for the taxpayer that do not extend
beyond the period prescribed by the 12-month rule are treated as having
a useful life that does not extend substantially beyond the close of
the taxable year. Thus, such amounts are not required to be capitalized
under the proposed regulations. Amounts paid to create rights or
benefits that do extend beyond the period prescribed by the 12-month
rule must be capitalized in full; no portion of these amounts is
considered to come within the scope of the 12-month rule on the ground
that such portion is allocable to rights or benefits that will expire
within the period prescribed by the 12-month rule.
The 12-month rule does not apply to amounts paid to create or
enhance financial interests or to amounts paid to create or enhance
self-created amortizable section 197 intangibles (as described in
section 197(c)(2)(A)). Application of the 12-month rule to self-created
amortizable section 197 intangibles, but not to amortizable section 197
intangibles acquired from another person, would result in inconsistent
treatment of amortizable section 197 intangibles. The IRS and Treasury
Department are reluctant to treat acquired amortizable section 197
intangibles different from self-created amortizable section 197
intangibles.
The proposed regulations clarify the interaction of the 12-month
rule with the economic performance rules contained in section 461(h) of
the Code. Nothing in these proposed regulations is intended to change
the application of section 461 of the Code, including the application
of the economic performance rules. In the case of a taxpayer using the
accrual method of accounting, section 461 requires that an item be
incurred before it is taken into account through capitalization or
deduction. For example, under the economic performance rules, amounts
prepaid for goods or services generally are not incurred, and therefore
may not be taken into account by an accrual method taxpayer, until such
time as the goods or services are provided to the taxpayer (subject to
the recurring item exception). Sec. 1.461-4(d)(2)(i). Thus, the 12-
month rule provided by the regulations does not permit an accrual
method taxpayer to deduct an amount prepaid for goods or services where
the amount has not been incurred under section 461 (for example, where
the taxpayer can not reasonably expect that it will be provided goods
or services within 3\1/2\ months after the date of payment). The
proposed regulations contain examples demonstrating the interaction of
the 12-month rule with the economic performance rules of section
461(h).
B. Application of 12-Month Rule to Contract Terminations
The proposed regulations clarify that, for purposes of applying the
12-month rule, an amount paid to terminate a contract described in Part
IV.F. of this preamble prior to its expiration date creates a benefit
for the taxpayer equal to the unexpired term of the agreement as of the
date of termination. Thus, for example, if a lessor incurs costs to
terminate a lease with an unexpired term of 10 months, the 12-month
rule will apply to those costs.
C. Rights of Indefinite Duration
The 12-month rule does not apply to contracts or other rights that
have an indefinite duration. Rights of indefinite duration include
rights that have no period of duration fixed by agreement or law or
that are not based on a period of time, but are based on a right to
provide or receive a fixed amount of goods or services. The IRS and
Treasury Department believe that, in many cases, application of the 12-
month rule to contracts or other rights that are not based on a period
of time would necessitate speculation regarding whether the contract or
other right could reasonably be expected to be completed within 12
months. In addition, the IRS and Treasury Department believe that
amounts paid to create or enhance such rights should be capitalized and
recovered through amortization, through a loss deduction upon
abandonment of the right, or through basis recovery upon sale.
Further, Sec. 1.167(a)-14(c) of the regulations provides rules for
amortizing costs to obtain a right to receive a fixed amount of
property or services. Under these rules, the basis of such right is
amortized for each taxable year by multiplying the basis of the right
by a fraction, the numerator of which is the amount of tangible
property or services received during the taxable year and the
denominator of which is the total amount of tangible property or
services received or to be received under the terms of the contract.
The IRS and Treasury Department believe that these amortization rules
provide a reasonable recovery method for many
[[Page 77709]]
rights that are required to be capitalized under these regulations, and
serve as a sufficient substitute for a 12-month rule.
D. Rights That Are Renewable
The proposed regulations provide rules for determining whether
renewal periods should be taken into account in determining the
treatment of a renewable contract with an initial term that falls
within the scope of the 12-month rule. The proposed regulations provide
that renewal periods are to be taken into account if there is a
``reasonable expectancy of renewal.'' Some commentators suggested that
renewals should be taken into account only if renewal is
``substantially likely'' or ``economically compelled.'' The IRS and
Treasury Department believe that the reasonable expectancy of renewal
test is a more appropriate standard, and note that this standard is
consistent with the standard provided in Sec. 1.167(a)-14(c)(3) of the
regulations for purposes of determining the amortization period for
certain contract rights.
Whether a reasonable expectancy of renewal exists depends on all
relevant facts and circumstances in existence at the time the contract
or other right is created. The fact that a particular contract is
ultimately renewed is not relevant in determining whether a reasonable
expectancy of renewal exists at the time the parties entered into the
contract. The proposed regulations provide factors that are significant
in determining whether a reasonable expectancy of renewal exists.
The IRS and Treasury Department are considering rules that permit
taxpayers who create, renew, or enhance a certain minimum number of
similar rights or benefits during a taxable year to pool those
transactions for purposes of applying the 12-month rule. The proposed
regulations provide a broad outline of one pooling method under
consideration by the IRS and Treasury Department. This method allows
taxpayers to apply the reasonable expectancy of renewal test to pools
of similar rights or benefits. Under this proposed method, taxpayers
are required to capitalize an expenditure to obtain a right or benefit
by reference to the reasonable expectancy of renewal for the pool. The
proposed regulations provide that, if less than 20 percent of the
rights or benefits in the pool are reasonably expected to be renewed,
the taxpayer need not capitalize any costs for the rights or benefits
in the pool. On the other hand, if more than 80 percent of the rights
or benefits in the pool are reasonably expected to be renewed, the
taxpayer must capitalize all costs (other than de minimis costs
described in Parts IV.E. and V.D.2. of this preamble) for the rights or
benefits in the pool. If 20 percent or more but 80 percent or less of
the rights or benefits in the pool are reasonably expected to be
renewed, the taxpayer must capitalize a percentage of costs
corresponding to the percentage of rights or benefits in the pool that
are reasonably expected to be renewed. The proposed regulations provide
that taxpayers may define a pool of similar contracts for this purpose
using any reasonable method. A reasonable method would include a
definition of a pool based on the type of customer and the type of
property or service provided.
The IRS and Treasury Department stress that the pooling methods
outlined in these proposed regulations are not effective unless these
pooling methods are ultimately promulgated in final regulations.
Accordingly, these proposed regulations do not provide authority for
taxpayers to adopt the pooling methods outlined herein. Public comments
are requested regarding the following specific issues related to
pooling (both with respect to pools established for purposes of
applying the 12-month rule and with respect to pools established for
purposes of applying the de minimis rules):
(a) Would pooling be a useful simplification measure for taxpayers?
(b) Should a pooling method be provided in final regulations, or
are rules governing pooling more appropriately issued in the form of
industry-specific guidance or other non-regulatory guidance (e.g.,
revenue procedure)?
(c) Should a pooling method be treated as a method of accounting
under section 446?
(d) Should the regulations define what constitutes ``similar''
contract rights or other rights for purposes of defining a pool? If so,
what factors should be considered in determining whether rights are
similar?
(e) Should the regulations require the use of the same pools for
depreciation purposes as are used for purposes of determining the
amount capitalized under the regulations? Is additional guidance
necessary to clarify the interaction of the pooling rules with the
rules in section 167 and Sec. 1.167(a)-8?
(f) The IRS and Treasury Department intend to require a minimum
number of similar transactions that a taxpayer must engage in during a
taxable year in order to be eligible to apply the pooling method.
Comments are requested regarding what this minimum number of similar
transactions should be.
VII. Safe Harbor Amortization
A. In General
The proposed regulations amend Sec. 1.167(a)-3 to provide a 15-
year safe harbor amortization period for certain created or enhanced
intangibles that do not have readily ascertainable useful lives. For
example, amounts paid to obtain certain memberships or privileges of
indefinite duration would be eligible for the safe harbor amortization
provision. Under the safe harbor, amortization is determined using a
straight-line method with no salvage value.
The prescribed 15-year period is consistent with the amortization
period prescribed by section 197. Many commentators suggested that any
safe harbor amortization period should be no longer than 60 months, and
noted that a 60-month amortization period is consistent with
amortization periods prescribed by sections 195 (start up
expenditures), 248 (organizational expenditures), and 709 (partnership
organization and syndication fees) of the Code. The IRS and Treasury
Department are concerned that an amortization period shorter than 15
years would create tension with section 197, and might encourage
attempts to circumvent the provisions of section 197.
The safe harbor amortization period does not apply to intangibles
acquired from another party or to created financial interests. These
intangibles are generally not amortizable, are amortizable under
section 197, or are amortizable over a period prescribed by other
provisions of the Code or regulations.
The safe harbor amortization period also does not apply to created
intangibles that have readily ascertainable useful lives on which
amortization can be based. Existing law permits taxpayers to amortize
intangible assets with reasonably estimable useful lives. Sec.
1.167(a)-3. For instance, prepaid expenses, contracts with a fixed
duration, and certain contract terminations have readily ascertainable
useful lives on which amortization can be based. Prepaid expenses are
amortized over the period covered by the prepayment. Amounts paid to
induce another to enter into a contract with a fixed duration are
amortized over the duration of the contract. Amounts paid by a lessor
to terminate a lease contract are amortized over the remaining term of
the lease. Peerless Weighing and Vending Machine Corp. v. Commissioner,
52 T.C. 850, 852 (1969).
The safe harbor amortization period does not overrule existing
amortization periods prescribed or prohibited by the
[[Page 77710]]
Code, regulations, or other guidance. See, e.g., section 167(f)(1)(A)
(prescribing a 36-month life for certain computer software); 171
(prescribing rules for determining the amortization period for bond
premium); 178 (prescribing the amortization period for costs to acquire
a lease); 197 (prescribing a 15-year life for certain intangible
assets); Sec. 1.167(a)-14(d)(1) (prescribing a 108-month useful life
for mortgage servicing rights).
Finally, the 15-year safe harbor does not apply to amounts paid in
connection with real property owned by another. As discussed in Part
IV.G. of this preamble, the proposed regulations provide a 25-year safe
harbor amortization period for those amounts.
B. Restructurings, Reorganizations and Transactions Involving the
Acquisition of Capital
The proposed regulations do not provide safe harbor amortization
for capitalized transaction costs that facilitate a stock issuance or
other transaction involving the acquisition of capital. The regulations
maintain the historical treatment of stock issuance costs and costs
that facilitate a recapitalization. Historically, such costs have been
treated as a reduction of capital proceeds from the transaction, and
not as a separate intangible asset that is amortizable over a useful
life. See Rev. Rul. 69-330 (1969-1 C.B. 51); Affiliated Capital Corp.
v. Commissioner, 88 T.C. 1157 (1987).
In addition, the proposed regulations do not allow safe harbor
amortization for capitalized transaction costs that facilitate a
restructuring or reorganization of a business entity. As discussed
below, comments are requested regarding the appropriateness of applying
the safe harbor amortization period to certain of these costs.
1. Acquirer's Costs in a Taxable Acquisition
The safe harbor amortization provisions do not apply to transaction
costs properly capitalized by an acquirer to facilitate the acquisition
of the stock or assets of a target corporation in a taxable
acquisition. In such a case, existing law provides that transaction
costs are properly capitalized to the basis of the stock or assets
acquired. See Woodward v. Commissioner, 397 U.S. 572 (1970). In the
case of a stock acquisition, the capitalized transaction costs are not
amortizable, but offset any subsequent gain or loss realized on the
disposition of the stock. In the case of an asset acquisition, the
capitalized transaction costs generally may be recovered as part of the
recovery of the basis of the assets.
2. Target's Costs in a Taxable Acquisition
The safe harbor amortization rules also do not apply to transaction
costs incurred by a target to facilitate the acquisition of its assets
by an acquirer in a taxable transaction. In such a case, the
transaction costs generally are an offset against any gain or loss
realized by the target on the disposition of its assets.
While the proposed regulations do not allow safe harbor
amortization of transaction costs capitalized by a target to facilitate
the acquisition of its stock by an acquirer in a taxable transaction,
the IRS and Treasury Department request comments on whether safe harbor
amortization should be allowed in such a transaction. Existing law
provides no useful life for these capitalized costs, and little
guidance concerning when taxpayers may recover these costs. See, e.g.,
INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992) (indicating that
where no specific asset or useful life can be ascertained, a
capitalized cost is deducted upon dissolution of the enterprise). The
IRS and Treasury Department believe that the application of a safe
harbor amortization period to such costs might help to eliminate much
of the current controversy that exists concerning the proper treatment
of these costs.
3. Acquirer's and Target's Costs in a Tax-Free Acquisition
In determining whether the safe harbor amortization provision
should apply to transaction costs that facilitate a tax-free
acquisition, threshold issues exist regarding the proper treatment of
capitalized costs. Comments are requested concerning the following
issues:
(a) Should an acquirer's capitalized transaction costs in a tax-
free acquisition of a target be added to the acquirer's basis in the
target's stock or assets acquired? If so, should amortization of such
costs under the safe harbor amortization provision be prohibited on the
ground that the capitalized costs are properly recovered as part of the
recovery of the basis of the assets (in the case of a transaction
treated as an asset acquisition) or upon the disposition of the stock
(in the case of a transaction treated as a stock acquisition)? On the
other hand, if the carryover basis rules of section 362(b) of the Code
prohibit the acquirer from increasing its basis in the acquired stock
or assets by the amount of the capitalized transaction costs, should
the capitalized transaction costs be viewed as a separate intangible
asset with an indefinite useful life?
(b) Should a target's capitalized transaction costs in a tax-free
acquisition that is treated as a stock acquisition be viewed as a
separate intangible asset with an indefinite useful life?
(c) Should a target's capitalized transaction costs in a tax-free
acquisition that is treated as an asset acquisition be viewed as an
intangible asset with an indefinite useful life, or are such costs
better viewed as a reduction of target's amount realized or as an
increase in target's basis in its assets immediately prior to the
acquisition?
(d) If an acquirer's (or a target's) capitalized transaction costs
are viewed as a separate intangible asset with an indefinite useful
life, should amortization be permitted for such costs under the safe
harbor amortization provision, or does section 197(e)(8) of the Code
evince a Congressional intent to prohibit any amortization of
transaction costs capitalized in a tax-free reorganization?
(e) To what extent should the safe harbor amortization provision
apply to capitalized transaction costs that facilitate tax-free
transactions other than the acquisitive transactions discussed above
(e.g., transactions under sections 351 and 355)?
4. Costs to Facilitate a Borrowing
Existing law requires that capitalized transaction costs incurred
to borrow money (debt issuance costs) be deducted over the term of the
debt. For example, see Enoch v. Commissioner, 57 T.C. 781 (1972). The
regulations do not propose to change this treatment. Accordingly, the
safe harbor amortization provision does not apply to capitalized debt
issuance costs. However, in order to conform the rules for debt
issuance costs with the rules for original issue discount, the proposed
regulations generally require the use of a constant yield method to
determine how much of these costs are deductible each year by the
borrower. See proposed Sec. 1.446-5.
VIII. Computer Software Issues
The ANPRM requested public comment on the rules and principles that
should apply in distinguishing acquired software from developed
software. Under existing law, costs to acquire software are
appropriately capitalized and may be amortized over 36 months or, in
some cases, 15 years. Sections 167(f) and 197(d)(1)(C)(iii). Costs to
develop software, on the other
[[Page 77711]]
hand, may be deducted as incurred in accordance with Rev. Proc. 2000-50
(2000-2 C.B. 601).
The determination of whether software is developed or acquired is a
factual inquiry that depends on an analysis of the activities performed
by the various parties to the software transaction. While a few
commentators identified factors that help to distinguish acquired
software from developed software, commentators also suggested that this
issue should be addressed in separate guidance, and not in the proposed
regulations.
The IRS and Treasury Department agree that the determination of
whether computer software is acquired or developed raises issues that
are beyond the scope of these proposed regulations. Accordingly, the
proposed regulations do not provide rules for distinguishing acquired
software from developed software. These issues will be addressed in
subsequent guidance.
Many commentators suggested that the proposed regulations should
provide guidance concerning the treatment of costs to implement
acquired software. For example, commentators noted that issues often
arise regarding the extent to which section 263(a) requires
capitalization of costs to implement Enterprise Resource Planning (ERP)
software. ERP software is an enterprise-wide database software system
that integrates business functions such as financial accounting, sales
and distribution, materials management, and production planning.
Implementation of an ERP system may take several years and generally
involves various categories of costs, including (1) costs to acquire
the ERP software package from the vendor, (2) costs to install the
acquired ERP software on the taxpayer's computer hardware and to
configure the software to the taxpayer's needs through the use of the
options and templates embedded in the software, (3) software
development costs, and (4) costs to train employees in the use of the
new software.
The proposed regulations do not specifically address the treatment
of ERP software. However, the IRS and Treasury Department expect that
the final regulations will address these costs and, subject to the
simplifying conventions provided in the regulations for employee
compensation, overhead, and de minimis transaction costs, will treat
such costs in a manner consistent with the treatment prescribed in
Private Letter Ruling 200236028 (June 4, 2002) (available in the IRS
Freedom of Information Act Reading Room, 1111 Constitution Avenue, NW.,
Washington, DC 20224). The IRS and Treasury Department request comments
on the treatment of ERP implementation costs under the principles
contained in these proposed regulations.
IX. Proposed Effective Date
These regulations are proposed to be applicable on the date on
which the final regulations are published in the Federal Register. The
regulations provide rules applicable to taxpayers that seek to change a
method of accounting to comply with the rules contained in the final
regulations. Taxpayers may not change a method of accounting in
reliance upon the rules contained in these proposed regulations until
the rules are published as final regulations in the Federal Register.
Upon publication of the final regulations, taxpayers must follow
the applicable procedures for obtaining the Commissioner's automatic
consent to a change in accounting method. The proposed regulations
provide that any change in a method of accounting is made using an
adjustment under section 481(a), but that such adjustment is determined
by taking into account only amounts paid or incurred on or after the
date the final regulations are published in the Federal Register.
The IRS and Treasury Department are concerned about the potential
administrative burden on taxpayers and the IRS that may result from a
section 481(a) adjustment that takes into account amounts paid or
incurred prior to the effective date of the regulations. Given the
potential for section 481(a) adjustments that originate many years
prior to the effective date of the regulations, the IRS and Treasury
Department question whether adequate documentation is available to
compute the adjustment with reasonable accuracy.
The IRS and Treasury Department request comments on whether there
are circumstances in which it is appropriate to permit a change in
method of accounting to be made using an adjustment under section
481(a) that takes into account amounts paid or incurred prior to the
effective date of the regulations. If there are such circumstances,
comments are requested on the appropriate number of taxable years prior
to the effective date of the regulations that taxpayers should be
permitted to look back for purposes of computing the adjustment.
Finally, the IRS and Treasury Department request comments on any
additional terms and conditions for changes in methods of accounting
that would be helpful to taxpayers in adopting the rules contained in
these regulations.
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in Executive Order
12866. Therefore, a regulatory assessment is not required. It also has
been determined that section 553(b) of the Administrative Procedure Act
(5 U.S.C. chapter 5) does not apply to these regulations, and, because
the regulations do not impose a collection of information on small
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not
apply. Pursuant to section 7805(f) of the Code, this notice of proposed
rulemaking will be submitted to the Chief Counsel for Advocacy of the
Small Business Administration for comment on its impact on small
business.
Comments and Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any written (a signed original and eight
(8) copies) or electronic comments that are submitted timely to the
IRS. The IRS and Treasury Department request comments on the clarity of
the proposed rules and how they can be made easier to understand. All
comments will be available for public inspection and copying.
A public hearing has been scheduled for April 22, 2003, beginning
at 10 a.m. in the IRS Auditorium, Internal Revenue Building, 1111
Constitution Avenue, NW., Washington, DC. Due to building security
procedures, visitors must enter at the Constitution Avenue entrance. In
addition, all visitors must present photo identification to enter the
building. Because of access restrictions, visitors will not be admitted
beyond the immediate entrance area more than 30 minutes before the
hearing starts. For information about having your name placed on the
building access list to attend the hearing, see the FOR FURTHER
INFORMATION CONTACT section of this preamble.
The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who
wish to present oral comments at the hearing must submit electronic or
written comments and an outline of the topics to be discussed and the
time to be devoted to each topic (signed original and eight (8) copies)
by April 1, 2003. A period of 10 minutes will be allotted to each
person for making comments. An agenda showing the schedule of speakers
will be prepared after the deadline for receiving outlines has passed.
Copies of the agenda will be available free of charge at the hearing.
[[Page 77712]]
Drafting Information
The principal author of these proposed regulations is Andrew J.
Keyso of the Office of Associate Chief Counsel (Income Tax and
Accounting). However, other personnel from the IRS and Treasury
Department participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART I--INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.167(a)-3 is amended by:
1. Adding a paragraph designation and heading to the undesignated
paragraph.
2. Adding paragraph (b).
The additions read as follows:
Sec. 1.167(a)-3 Intangibles.
(a) In general. * * *
(b) Safe harbor amortization for certain intangible assets--(1)
Amortization period. For purposes of determining the depreciation
allowance referred to in paragraph (a) of this section, a taxpayer may
treat an intangible asset as having a useful life equal to 15 years
unless--
(i) An amortization period for the intangible asset is specifically
prescribed or prohibited by the Internal Revenue Code, regulations, or
other published guidance;
(ii) The intangible asset is described in Sec. 1.263(a)-4(c)
(relating to intangibles acquired from another person) or Sec.
1.263(a)-4(d)(2) (relating to created financial interests);
(iii) The intangible asset has a useful life that is readily
ascertainable; or
(iv) The intangible asset is described in Sec. 1.263(a)-4(d)(8)
(relating to certain benefits arising from the provision, production,
or improvement of real property), in which case the taxpayer may treat
the intangible asset as having a useful life equal to 25 years.
(2) Applicability to restructurings, reorganizations, and
acquisitions of capital. The safe harbor amortization period provided
by paragraph (b)(1) of this section does not apply to an amount
required to be capitalized by Sec. 1.263(a)-4(b)(1)(iii) (relating to
amounts paid to facilitate a restructuring, reorganization or
transaction involving the acquisition of capital).
(3) Depreciation method. A taxpayer that determines its
depreciation allowance for an intangible asset using the 15-year
amortization period prescribed by paragraph (b)(1) of this section (or
the 25-year amortization period in the case of an intangible asset
described in Sec. 1.263(a)-4(d)(8)) must determine the allowance by
amortizing the basis of the intangible asset (as determined under
section 167(c) and without regard to salvage value) ratably over the
amortization period beginning on the first day of the month in which
the intangible asset is placed in service by the taxpayer. The
intangible asset is not eligible for amortization in the month of
disposition.
Par. 3. Section 1.263(a)-4 is added to read as follows:
Sec. 1.263(a)-4 Amounts paid to acquire, create, or enhance
intangible assets.
(a) Overview. This section provides rules for applying section
263(a) to amounts paid to acquire, create, or enhance intangible
assets. Except to the extent provided in paragraph (d)(8) of this
section, the rules provided by this section do not apply to amounts
paid to acquire, create, or enhance tangible assets. Paragraph (b) of
this section provides a general principle of capitalization. Paragraphs
(c) and (d) of this section identify intangibles for which
capitalization is specifically required under the general principle.
Paragraph (e) of this section provides rules for determining the extent
to which taxpayers must capitalize transaction costs. Paragraph (f) of
this section provides a 12-month rule intended to simplify the
application of the general principle to certain payments that create
benefits of a brief duration. Additional rules and examples relating to
these provisions are provided in paragraphs (g) through (n) of this
section. The applicability date of the rules in this section is
provided in paragraph (o) of this section.
(b) Capitalization of intangible assets--(1) In general. Except as
otherwise provided in chapter 1 of the Internal Revenue Code, a
taxpayer must capitalize--
(i) An amount paid to acquire, create, or enhance an intangible
asset (within the meaning of paragraph (b)(2) of this section);
(ii) An amount paid to facilitate (within the meaning of paragraph
(e)(1) of this section) the acquisition, creation, or enhancement of an
intangible asset; and
(iii) An amount paid to facilitate (within the meaning of paragraph
(e)(1) of this section) a restructuring or reorganization of a business
entity or a transaction involving the acquisition of capital, including
a stock issuance, borrowing, or recapitalization.
(2) Intangible asset--(i) In general. For purposes of this section,
the term intangible asset means--
(A) An intangible described in paragraph (c) of this section
(relating to acquired intangibles);
(B) An intangible described in paragraph (d) of this section
(relating to certain created or enhanced intangibles);
(C) A separate and distinct intangible asset within the meaning of
paragraph (b)(3) of this section; or
(D) A future benefit identified in published guidance in the
Federal Register or in the Internal Revenue Bulletin (see Sec.
601.601(d)(2)(ii)(b) of this chapter) as an intangible asset for which
capitalization is required under this section.
(ii) Published guidance. Any published guidance identifying a
future benefit as an intangible asset for which capitalization is
required under paragraph (b)(2)(i)(D) of this section applies only to
amounts paid on or after the date of publication of the guidance.
(3) Separate and distinct intangible asset--(i) Definition. The
term separate and distinct intangible asset means a property interest
of ascertainable and measurable value in money's worth that is subject
to protection under applicable state or federal law and the possession
and control of which is intrinsically capable of being sold,
transferred, or pledged (ignoring any restrictions imposed on
assignability). The determination of whether an amount is paid to
acquire, create, or enhance a separate and distinct intangible asset is
made as of the taxable year during which the payment is made.
(ii) Creation or termination of contract rights. Amounts paid to
another party to create or originate an agreement with that party that
produces rights or benefits for the taxpayer do not create a separate
and distinct intangible asset within the meaning of this paragraph
(b)(3). Further, amounts paid to another party to terminate an
agreement with that party do not create a separate and distinct
intangible asset within the meaning of this paragraph (b)(3). See
paragraphs (d)(2), (6) and (7) of this section for rules that
specifically require capitalization of amounts paid to create or
terminate certain agreements. See paragraph (e)(1)(ii) of this section
for rules relating to the treatment of certain termination payments
that facilitate another transaction for which capitalization is
required under this section.
[[Page 77713]]
(c) Acquired intangibles--(1) In general. A taxpayer must
capitalize amounts paid to another party to acquire an intangible from
that party in a purchase or similar transaction. Intangibles within the
scope of this paragraph (c) include, but are not limited to, the
following (if acquired from another party in a purchase or similar
transaction):
(i) An ownership interest in a corporation, partnership, trust,
estate, limited liability company, or other similar entity.
(ii) A debt instrument, deposit, stripped bond, stripped coupon
(including a servicing right treated for federal income tax purposes as
a stripped coupon), regular interest in a REMIC or FASIT, or any other
intangible treated as debt for federal income tax purposes.
(iii) A financial instrument, including, but not limited to --
(A) A letter of credit;
(B) A credit card agreement;
(C) A notional principal contract;
(D) A foreign currency contract;
(E) A futures contract;
(F) A forward contract (including an agreement under which the
taxpayer has the right and obligation to provide or to acquire property
(or to be compensated for such property));
(G) An option (including an agreement under which the taxpayer has
the right to provide or to acquire property (or to be compensated for
such property)); and
(H) Any other financial derivative.
(iv) An endowment contract, annuity contract, or insurance contract
that has or may have cash value.
(v) Non-functional currency.
(vi) A lease contract.
(vii) A patent or copyright.
(viii) A franchise, trademark or tradename (as defined in Sec.
1.197-2(b)(10)).
(ix) An assembled workforce (as defined in Sec. 1.197-2(b)(3)).
(x) Goodwill (as defined in Sec. 1.197-2(b)(1)) or going concern
value (as defined in Sec. 1.197-2(b)(2)).
(xi) A customer list.
(xii) A servicing right (for example, a mortgage servicing right).
(xiii) A customer-based intangible (as defined in Sec. 1.197-
2(b)(6)) or supplier-based intangible (as defined in Sec. 1.197-
2(b)(7)).
(xiv) Computer software.
(2) Readily available software. An amount paid to obtain a
nonexclusive license for software that is (or has been) readily
available to the general public on similar terms and has not been
substantially modified (within the meaning of Sec. 1.197-2(c)(4)) is
treated for purposes of this paragraph (c) as an amount paid to another
party to acquire an intangible from that party in a purchase or similar
transaction.
(3) Intangibles acquired from an employee. Amounts paid to an
employee to acquire an intangible from that employee are not required
to be capitalized under this section if the amounts are treated as
compensation for personal services includible in the employee's income
under section 61 or 83. For purposes of this section, whether an
individual is an employee is determined in accordance with the rules
contained in section 3401(c) and the regulations thereunder.
(4) Examples. The following examples illustrate the rules of this
paragraph (c):
Example 1. Financial instrument. X corporation, a
commercial bank, purchases a portfolio of existing loans from Y
corporation, another financial institution. X pays Y $2,000,000 in
exchange for the portfolio. The $2,000,000 paid to Y constitutes an
amount paid to acquire an intangible from Y and must be
capitalized.
Example 2. Option. W corporation owns all of the outstanding
stock of X corporation. Y corporation holds a call option entitling
it to purchase from W all of the outstanding stock of X at a certain
price per share. Z corporation acquires the call option from Y in
exchange for $5,000,000. The $5,000,000 paid to Y constitutes an
amount paid to acquire an intangible from Y and must be
capitalized.
Example 3. Ownership interest in a corporation. Same as Example
2, but assume Z exercises its option and purchases from W all of the
outstanding stock of X in exchange for $100,000,000. The
$100,000,000 paid to W constitutes an amount paid to acquire an
intangible from W and must be capitalized.
Example 4. Customer list. N corporation, a retailer, sells its
products exclusively through its catalog and mail order system. N
purchases a customer list from R corporation. N pays R $100,000 in
exchange for the customer list. The $100,000 paid to R constitutes
an amount paid to acquire an intangible from R and must be
capitalized.
Example 5. Lease. V corporation seeks to lease commercial
property in a prominent downtown location of city R. V identifies
desirable property in city R that is currently under lease by X
corporation to W corporation under a 10-year assignable lease. V
pays W $50,000 to acquire the lease and relocates its operations
from city O to city R. The $50,000 paid to W constitutes an amount
paid to W to acquire an intangible from W and must be capitalized.
Example 6. Goodwill. Z corporation pays W corporation
$10,000,000 to purchase all of the assets of W in a transaction that
constitutes an applicable asset acquisition under section 1060(c).
Of the $10,000,000 consideration paid in the transaction, $9,000,000
is allocable to tangible assets purchased from W and $1,000,000 is
allocable to goodwill. The $1,000,000 allocable to goodwill
constitutes an amount paid to W to acquire intangibles from W and
must be capitalized.
(d) Created intangibles--(1) In general. Except as provided in
paragraph (f) of this section (relating to the 12-month rule), a
taxpayer must capitalize amounts paid to create or enhance an
intangible described in this paragraph (d).
(2) Financial interests--(i) In general. A taxpayer must capitalize
amounts paid to another party to create or originate with that party
any of the following financial interests, whether or not the interest
is regularly traded on an established market:
(A) An ownership interest in a corporation, partnership, trust,
estate, limited liability company, or other similar entity.
(B) A debt instrument, deposit, stripped bond, stripped coupon
(including a servicing right treated for federal income tax purposes as
a stripped coupon), regular interest in a REMIC or FASIT, or any other
intangible treated as debt for federal income tax purposes.
(C) A financial instrument, including, but not limited to--
(1) A letter of credit;
(2) A credit card agreement;
(3) A notional principal contract;
(4) A foreign currency contract;
(5) A futures contract;
(6) A forward contract (including an agreement under which the
taxpayer has the right and obligation to provide or to acquire property
(or to be compensated for such property));
(7) An option (including an agreement under which the taxpayer has
the right to provide or to acquire property (or to be compensated for
such property)); and
(8) Any other financial derivative.
(D) An endowment contract, annuity contract, or insurance contract
that has or may have cash value.
(E) Non-functional currency.
(ii) Exception for current and prior sales. An amount is not
required to be capitalized under paragraph (d)(2)(i)(C)(6) or (7) of
this section if the amount is allocable to property required to be
provided or acquired by the taxpayer prior to the end of the taxable
year in which the amount is paid.
(iii) Coordination with other provisions of this paragraph (d). An
amount described in this paragraph (d)(2) that is also described
elsewhere in paragraph (d) of this section is treated as described only
in this paragraph (d)(2).
(iv) Examples. The following examples illustrate the rules of this
paragraph (d)(2):
Example 1. Loan. X corporation, a commercial bank,
makes a loan to A in the
[[Page 77714]]
principal amount of $250,000. Under paragraph (d)(2)(i)(B) of this
section, the $250,000 principal amount of the loan paid to A
constitutes an amount paid to another party to create a financial
instrument with that party and must be capitalized.
Example 2. Option. W corporation owns all of the outstanding
stock of X corporation. Y corporation pays W $1,000,000 in exchange
for W's grant of a 3-year call option to Y permitting Y to purchase
all of the outstanding stock of X at a certain price per share.
Under paragraph (d)(2)(i)(C)(7) of this section, Y's payment of
$1,000,000 to W constitutes an amount paid to another party to
create or originate an option with that party and must be
capitalized.
Example 3. Partnership interest. Z corporation pays $10,000 to
P, a partnership, in exchange for an ownership interest in P. Under
paragraph (d)(2)(i)(A) of this section, Z's payment of $10,000 to P
constitutes an amount paid to another party to create an ownership
interest in a partnership with that party and must be capitalized.
Example 4. Take or pay contract. Q corporation, a producer of
natural gas, pays $1,000,000 to R during 2002 to induce R
corporation to enter into a 5-year ``take or pay'' gas purchase
contract. Under the contract, R is liable to pay for a specified
minimum amount of gas, whether or not R takes such gas. Under
paragraph (d)(2)(i)(C)(6) of this section, Q's payment is an amount
paid to another party to induce that party to enter into an
agreement providing Q the right and obligation to provide property
or be compensated for such property, regardless of whether the
property is provided. Because the agreement does not require that
the property be provided prior to the end of the taxable year in
which the amount is paid, Q must capitalize the entire $1,000,000
paid to R.
Example 5. Agreement to provide property. P corporation pays R
corporation $1,000,000 in exchange for R's agreement to purchase
1,000 units of P's product at any time within the three succeeding
calendar years. The agreement describes P's $1,000,000 as a sales
discount. Under paragraph (d)(2)(i)(C)(6) of this section, P's
$1,000,000 payment is an amount paid to induce R to enter into an
agreement providing P the right and obligation to provide property.
Because the agreement does not require that the property be provided
prior to the end of the taxable year in which the amount is paid, P
must capitalize the entire $1,000,000 payment.
Example 6. Customer incentive payment. S corporation, a computer
manufacturer, seeks to develop a business relationship with V
corporation, a computer retailer. As an incentive to encourage V to
purchase computers from S, S enters into an agreement with V under
which S agrees that, if V purchases $20,000,000 of computers from S
within 3 years from the date of the agreement, S will pay V
$2,000,000 on the date that V reaches the $20,000,000 threshold. V
reaches the $20,000,000 threshold during the third year of the
agreement, and S pays V $2,000,000. S is not required to capitalize
its payment to V under this paragraph (d)(2) because the payment
does not provide S the right to provide property. Moreover, the
agreement between S and V requires that the computers be provided
prior to the end of the taxable year in which the $2,000,000 is
paid. In addition, as provided in paragraph (b)(3)(ii) of this
section, S's $2,000,000 payment does not create or enhance a
separate and distinct intangible asset for S within the meaning of
paragraph (b)(3)(i) of this section.
Example 7. Sales discount. P corporation, a sofa manufacturer
that uses the calendar year for federal income tax purposes, seeks
to develop a business relationship with R corporation, a furniture
retailer. In 2002, P enters into a 5-year agreement with R under
which P agrees to reimburse 10 percent of the purchase price paid by
R if R purchases more than 1,000 sofas in a single order. In
addition, under the agreement, R agrees to purchase 2,000 sofas from
P in a single order for delivery during 2002. At the time the
agreement is executed, P pays R $20,000, reflecting the 10 percent
discount on the first 2,000 sofas to be purchased by R during 2002.
The $20,000 payment provides P the right and obligation to provide
property (2,000 sofas). Nevertheless, because the agreement requires
that the sofas be provided prior to the end of the taxable year in
which the amount is paid, P is not required to capitalize its
$20,000 payment under this paragraph (d)(2). In addition, as
provided in paragraph (b)(3)(ii) of this section, P's $20,000
payment does not create or enhance a separate and distinct
intangible asset for P within the meaning of paragraph (b)(3)(i) of
this section.
(3) Prepaid expenses--(i) In general. A taxpayer must capitalize
amounts prepaid for benefits to be received in the future.
(ii) Examples. The following examples illustrate the rules of this
paragraph (d)(3):
Example 1. Prepaid insurance. N corporation, an accrual method
taxpayer, pays $10,000 to an insurer to obtain an insurance policy
with a 3-year term. The $10,000 is an amount prepaid by N for
benefits to be received in the future and must be capitalized under
this paragraph (d)(3).
Example 2. Prepaid rent. X corporation, a cash method taxpayer,
enters into a 24-month lease of office space. At the time of the
lease signing, X prepays $240,000. No other amounts are due under
the lease. The $240,000 is an amount prepaid by X for benefits to be
received in the future and must be capitalized under this paragraph
(d)(3).
(4) Certain memberships and privileges--(i) In general. A taxpayer
must capitalize amounts paid to an organization to obtain or renew a
membership or privilege from that organization. A taxpayer is not
required to capitalize under this paragraph (d)(4) an amount paid to
obtain certification of the taxpayer's products, services, or business
processes.
(ii) Examples. The following examples illustrate the rules of this
paragraph (d)(4):
Example 1. Hospital privilege. B, a physician, pays $10,000 to Y
corporation to obtain lifetime staff privileges at a hospital
operated by Y. B must capitalize the $10,000 payment under this
paragraph (d)(4).
Example 2. Initiation fee. X corporation pays a $50,000
initiation fee to obtain membership in a social club. X must
capitalize the $50,000 payment under this paragraph (d)(4).
Example 3. Product rating. V corporation, an automobile
manufacturer, pays W corporation, a national quality ratings
association, $100,000 to conduct a study and provide a rating of the
quality and safety of a line of V's automobiles. V's payment is an
amount paid to obtain a certification of V's product and is not
required to be capitalized under this paragraph (d)(4).
Example 4. Business process certification. Z corporation, a
manufacturer, seeks to obtain a certification that its quality
control standards meet a series of international standards known as
ISO 9000. Z pays $50,000 to an independent registrar to obtain a
certification from the registrar that Z's quality management system
conforms to the ISO 9000 standard. Z's payment is an amount paid to
obtain a certification of Z's business processes and is not required
to be capitalized under this paragraph (d)(4).
(5) Certain rights obtained from a governmental agency--(i) In
general. A taxpayer must capitalize amounts paid to a governmental
agency to obtain or renew a trademark, trade name, copyright, license,
permit, franchise, or other similar right granted by that governmental
agency.
(ii) Examples. The following examples illustrate the rules of this
paragraph (d)(5):
Example 1. Business license. X corporation pays $15,000 to state
Y to obtain a business license that is valid indefinitely. Under
this paragraph (d)(5), the amount paid to state Y is an amount paid
to a government agency for a right granted by that agency.
Accordingly, X must capitalize the $15,000 payment.
Example 2. Bar admission. A, an individual, pays $1,000 to an
agency of state Z to obtain a license to practice law in state Z
that is valid indefinitely, provided A adheres to the requirements
governing the practice of law in state Z. Under this paragraph
(d)(5), the amount paid to state Z is an amount paid to a government
agency for a right granted by that agency. Accordingly, A must
capitalize the $1,000 payment.
(6) Certain contract rights--(i) In general. Except as otherwise
provided in this paragraph (d)(6), a taxpayer must capitalize amounts
paid to another party to induce that party to enter into, renew, or
renegotiate--
(A) An agreement providing the taxpayer the right to use tangible
or intangible property or the right to be compensated for the use of
such property;
(B) An agreement providing the taxpayer the right to provide or to
[[Page 77715]]
acquire services (or the right to be compensated for such services); or
(C) A covenant not to compete or an agreement having substantially
the same effect as a covenant not to compete (except, in the case of an
agreement that requires the performance of services, to the extent that
the amount represents reasonable compensation for services actually
rendered).
(ii) De minimis amounts. A taxpayer is not required to capitalize
amounts paid to another party (or parties) to induce that party (or
those parties) to enter into, renew, or renegotiate an agreement
described in paragraph (d)(6)(i) of this section if the aggregate of
all amounts paid to that party (or those parties) with respect to the
agreement does not exceed $5,000. If the aggregate of all amounts paid
to the other party (or parties) with respect to that agreement exceeds
$5,000, then all amounts must be capitalized. In general, a taxpayer
must determine whether the rules of this paragraph (d)(6)(ii) apply by
accounting for the amounts paid with respect to each agreement.
However, a taxpayer may elect to establish one or more pools of
agreements for purposes of determining the amounts paid with respect to
an agreement. Under this pooling method, the amounts paid with respect
to each agreement included in the pool is equal to the average amount
paid with respect to all agreements included in the pool. A taxpayer
computes the average amount paid with respect to all agreements
included in the pool by dividing the sum of all amounts paid with
respect to all agreements included in the pool by the number of
agreements included in the pool. See paragraph (h) of this section for
additional rules relating to pooling.
(iii) Exceptions--(A) Current and prior sales. An amount is not
required to be capitalized under paragraph (d)(6)(i)(B) of this section
if the amount is allocable to services required to be provided or
acquired by the taxpayer prior to the end of the taxable year in which
the amount is paid.
(B) Lessee construction allowances. Paragraph (d)(6)(i) of this
section does not apply to amounts paid by a lessor to a lessee as a
construction allowance for tangible property (see, for example, section
110).
(iv) Examples. The following examples illustrate the rules of this
paragraph (d)(6):
Example 1. New lease agreement. V seeks to lease commercial
property in a prominent downtown location of city R. V pays the
owner of the commercial property $50,000 as an inducement to enter
into a 10-year lease with V. V's payment is an amount paid to
another party to induce that party to enter into an agreement
providing V the right to use tangible property. Because the $50,000
payment exceeds $5,000, no portion of the amount paid to Z is de
minimis for purposes of paragraph (d)(6)(ii) of this section. Under
paragraph (d)(6)(i)(A) of this section, V must capitalize the entire
$50,000 payment.
Example 2. Modification of lease agreement. Partnership Y leases
a piece of equipment for use in its business from Z corporation.
When the lease has a remaining term of 3 years, Y requests that Z
modify the lease by extending the remaining term by 5 years. Y pays
$50,000 to Z in exchange for Z's agreement to modify the existing
lease. Y's payment of $50,000 is an amount paid to induce Z to
renegotiate an agreement providing Y the right to use property.
Because the $50,000 payment exceeds $5,000, no portion of the amount
paid to Z is de minimis for purposes of paragraph (d)(6)(ii) of this
section. Under paragraph (d)(6)(i)(A) of this section, Y must
capitalize the entire $50,000 paid to induce Z to renegotiate the
lease.
Example 3. Covenant not to compete. R corporation enters into an
agreement with A, an individual, that prohibits A from competing
with R for a period of three years. To encourage A to enter into the
agreement, R agrees to pay A $100,000 upon the signing of the
agreement. R's payment is an amount paid to another party to induce
that party to enter into a covenant not to compete. Because the
$100,000 payment exceeds $5,000, no portion of the amount paid to A
is de minimis for purposes of paragraph (d)(6)(ii) of this section.
Under paragraph (d)(6)(i)(C) of this section, R must capitalize the
entire $100,000 paid to A to induce A to enter into the covenant not
to compete.
Example 4. De minimis payments. X corporation is engaged in the
business of providing wireless telecommunications services to
customers. To induce customer B to enter into a 3-year
telecommunications contract, X provides B with a free wireless
telephone. X pays $300 to purchase the wireless telephone. X's
provision of a wireless telephone to B is an amount paid to B to
induce B to enter into an agreement providing X the right to provide
services, as described in paragraph (d)(6)(i)(B) of this section.
Because the amount of the inducement is $300, the amount of the
inducement is de minimis under paragraph (d)(6)(ii) of this section.
Accordingly, X is not required to capitalize the amount of the
inducement provided to B.
(7) Certain contract terminations--(i) In general. A taxpayer must
capitalize amounts paid to another party to terminate--
(A) A lease of real or tangible personal property between the
taxpayer (as lessor) and that party (as lessee);
(B) An agreement that grants that party the exclusive right to
acquire or use the taxpayer's property or services or to conduct the
taxpayer's business; or
(C) An agreement that prohibits the taxpayer from competing with
that party or from acquiring property or services from a competitor of
that party.
(ii) Examples. The following examples illustrate the rules of this
paragraph (d)(7):
Example 1. Termination of exclusive license agreement. On July
1, 2001, N enters into a license agreement with R corporation under
which N grants R the exclusive right to manufacture and distribute
goods using N's design and trademarks for a period of 10 years. On
June 30, 2003, N pays R $5,000,000 in exchange for R's agreement to
terminate the exclusive license agreement. N's payment to terminate
its license agreement with R constitutes a payment to terminate an
exclusive license to use the taxpayer's property, as described in
paragraph (d)(7)(i)(B) of this section. Accordingly, N must
capitalize its $5,000,000 payment to R.
Example 2. Termination of exclusive distribution agreement. On
March 1, 2001, L, a manufacturer, enters into an agreement with M
granting M the right to be the sole distributor of L's products in
state X for 10 years. On July 1, 2004, L pays M $50,000 in exchange
for M's agreement to terminate the distribution agreement. L's
payment to terminate its agreement with M constitutes a payment to
terminate an exclusive right to acquire L's property, as described
in paragraph (d)(7)(i)(B) of this section. Accordingly, L must
capitalize its $50,000 payment to M.
Example 3. Termination of covenant not to compete. On February
1, 2001, Y corporation enters into a covenant not to compete with Z
corporation that prohibits Y from competing with Z in city V for a
period of 5 years. On January 31, 2003, Y pays Z $1,000,000 in
exchange for Z's agreement to terminate the covenant not to compete.
Y's payment to terminate the covenant not to compete with Z
constitutes a payment to terminate an agreement that prohibits Y
from competing with Z, as described in paragraph (d)(7)(i)(C) of
this section. Accordingly, Y must capitalize its $1,000,000 payment
to Z.
Example 4. Termination of exclusive right to acquire property. W
corporation owns one-half of the outstanding stock of X corporation.
On July 1, 2002, W grants Y corporation a 5-year call option that
permits Y to purchase all of W's stock in X. On June 30, 2004, W
pays Y $50,000 to terminate the option. W's payment to terminate the
option with Y constitutes a payment to terminate an exclusive right
to acquire W's property, as described in paragraph (d)(7)(i)(B) of
this section. Accordingly, W must capitalize its $50,000 payment to
Y.
Example 5. Termination of supply contract. During 2000, Q
corporation enters into a 10-year agreement with R corporation under
which R agrees to fulfill all of Q's requirements for packaging
materials and supplies used by Q in the distribution of Q's goods.
During 2005, Q determines that its contract with R has become
unprofitable for Q and seeks to terminate the contract. Q pays R
$100,000 to terminate the contract. Q's payment to terminate the
supply contract with R is a payment to terminate an agreement not
described in this paragraph (d)(7). Accordingly, Q is not required
to capitalize the $100,000 payment to R under this paragraph (d)(7).
In addition, as provided
[[Page 77716]]
in paragraph (b)(3)(ii) of this section, Q's $1,000,000 payment does
not create or enhance a separate and distinct intangible asset for Q
within the meaning of paragraph (b)(3)(i) of this section.
Example 6. Termination of merger agreement. N corporation enters
into an agreement with U corporation under which N and U agree to
merge. Prior to the merger, N decides that its business will be more
successful if it does not merge with U. N pays U $10,000,000 to
terminate the agreement. At the time of the payment, N is not under
an agreement to merge with any other entity. N's payment to
terminate the merger agreement with U is a payment to terminate an
agreement not described in this paragraph (d)(7). Accordingly, N is
not required to capitalize the $10,000,000 payment under this
paragraph (d)(7). In addition, as provided in paragraph (b)(3)(ii)
of this section, N's $10,000,000 payment does not create or enhance
a separate and distinct intangible asset for N within the meaning of
paragraph (b)(3)(i) of this section.
(8) Certain benefits arising from the provision, production, or
improvement of real property--(i) In general. A taxpayer must
capitalize amounts paid for real property relinquished to another, or
amounts paid to produce or improve real property owned by another, if
the real property can reasonably be expected to produce significant
economic benefits for the taxpayer.
(ii) Exclusions. A taxpayer is not required to capitalize an amount
under paragraph (d)(8)(i) of this section to the extent the payment--
(A) Is part of a transaction involving the sale of the real
property by the taxpayer;
(B) Is part of the sale of services by the taxpayer to produce or
improve the real property;
(C) Is a payment by the taxpayer for some other property or service
provided to the taxpayer; or
(D) Is a payment by the taxpayer to another party to create an
intangible described in paragraph (d) of this section (other than in
this paragraph (d)(8)).
(iii) Real property. For purposes of this paragraph (d)(8), real
property includes property that is affixed to real property and that
will ordinarily remain affixed for an indefinite period of time, such
as roads, bridges, tunnels, pavements, wharves and docks, breakwaters
and sea walls, elevators, power generation and transmission facilities,
and pollution control facilities.
(iv) Impact fees and dedicated improvements. Paragraph (d)(8)(i) of
this section does not apply to amounts paid to satisfy one-time charges
imposed by a state or local government against new development (or
expansion of existing development) to finance specific offsite capital
improvements for general public use that are necessitated by the new or
expanded development. In addition, paragraph (d)(8)(i) of this section
does not apply to amounts paid for real property or improvements to
real property constructed by the taxpayer where the real property or
improvements benefit new development or expansion of existing
development, are immediately transferred to a state or local government
for dedication to the general public use, and are maintained by the
state or local government. See section 263A and the regulations
thereunder for capitalization rules that apply to amounts referred to
in this paragraph (d)(8)(iv).
(v) Examples. The following examples illustrate the rules of this
paragraph (d)(8):
Example 1. Amount paid to produce real property owned by
another. W corporation operates a quarry on the east side of a river
in city Z and a crusher on the west side of the river. City Z's
existing bridges are of insufficient capacity to be traveled by
trucks in transferring stone from W's quarry to its crusher. As a
result, the efficiency of W's operations is greatly reduced. W
contributes $1,000,000 to City Z to defray in part the cost of
construction of a publicly owned bridge capable of accommodating W's
trucks. W's payment to city Z is an amount paid to produce real
property (within the meaning of paragraph (d)(8)(iii) of this
section) that can reasonably be expected to produce significant
economic benefits for W. Under paragraph (d)(8)(i) of this section,
W must capitalize the $1,000,000 paid to city Z.
Example 2. Dedicated improvements. X corporation is engaged in
the development and sale of residential real estate. In connection
with a residential real estate project under construction by X in
city Z, X is required by city Z to construct ingress and egress
roads to and from its project and immediately transfer the roads to
city Z for dedication to general public use. The roads will be
maintained by city Z. X pays its subcontractor $100,000 to construct
the ingress and egress roads. X's payment is a dedicated improvement
within the meaning of paragraph (d)(8)(iv) of this section.
Accordingly, X is not required to capitalize the $100,000 payment
under this paragraph (d)(8). See section 263A and the regulations
thereunder for capitalization rules that apply to amounts referred
to in paragraph (d)(8)(iv) of this section.
(9) Defense or perfection of title to intangible property--(i) In
general. A taxpayer must capitalize amounts paid to another party to
defend or perfect title to intangible property where that other party
challenges the taxpayer's title to the intangible property.
(ii) Example. The following example illustrates the rules of this
paragraph (d)(9):
Example. Defense of title. R corporation claims to own an
exclusive patent on a particular technology. U corporation brings a
lawsuit against R, claiming that U is the true owner of the patent,
and that R stole the technology from U. The sole issue in the suit
involves the validity of R's patent. R chooses to settle the suit by
paying U $100,000 in exchange for U's release of all future claim to
the patent. R's payment to U is an amount paid to defend or perfect
title to intangible property under paragraph (d)(9) of this section
and must be capitalized.
(e) Transaction costs--(1) Scope of facilitate--(i) In general. An
amount is paid to facilitate a transaction described in paragraph
(b)(1)(ii) of this section (an acquisition, creation, or enhancement of
an intangible asset) or to facilitate a transaction described in
paragraph (b)(1)(iii) of this section (a restructuring or
reorganization of a business entity or a transaction involving the
acquisition of capital) if the amount is paid in the process of
pursuing the transaction. Whether an amount is paid in the process of
pursuing a transaction is determined based on all facts and
circumstances. The fact that an amount would (or would not) have been
paid but-for the transaction is not relevant in determining whether the
amount is paid to facilitate the transaction.
(ii) Treatment of termination payments in integrated transactions.
An amount paid to terminate (or facilitate the termination of) an
existing agreement constitutes an amount paid to facilitate a
transaction referred to in paragraph (e)(1)(i) of this section if the
transaction is expressly conditioned on the termination of the existing
agreement.
(iii) Ordering rules. An amount required to be capitalized under
paragraph (b)(1)(i) of this section does not facilitate a transaction
referred to in paragraph (e)(1)(i) of this section. In addition, an
amount paid to facilitate a borrowing does not facilitate another
transaction (other than the borrowing) referred to in paragraph
(e)(1)(i) of this section.
(2) Transaction. For purposes of this section, the term transaction
means all of the factual elements comprising an acquisition, creation,
or enhancement of an intangible asset (or a restructuring,
reorganization, or transaction involving the acquisition of capital)
and includes a series of steps carried out as part of a single plan.
Thus, a transaction can involve more than one invoice and more than one
intangible asset. For example, a purchase of intangible assets under
one purchase agreement may constitute a single transaction,
notwithstanding the fact that the acquisition involves multiple
intangible assets and the amounts paid to facilitate the
[[Page 77717]]
acquisition are capable of being allocated among the various intangible
assets acquired.
(3) Simplifying conventions--(i) In general. For purposes of this
paragraph (e), compensation paid to employees (including bonuses and
commissions paid to employees), overhead, and de minimis costs (within
the meaning of paragraph (e)(3)(ii) of this section) are treated as
amounts that do not facilitate a transaction referred to in paragraph
(e)(1)(i) of this section. For purposes of this section, whether an
individual is an employee is determined in accordance with the rules
contained in section 3401(c) and the regulations thereunder.
(ii) De minimis costs--(A) In general. Except as provided in
paragraph (e)(3)(ii)(B) of this section, the term de minimis costs
means amounts referred to in paragraph (e)(1)(i) of this section that
are paid with respect to a transaction if, in the aggregate, the
amounts do not exceed $5,000. If the amounts exceed $5,000, no portion
of the amounts is a de minimis cost within the meaning of this
paragraph (e)(3)(ii)(A). In determining the amount of transaction costs
paid with respect to a transaction, a taxpayer generally must account
for the actual costs paid with respect to the transaction. However, a
taxpayer may elect to determine the amount of transaction costs paid
with respect to a transaction using the average cost pooling method
described in paragraph (e)(3)(ii)(C) of this section.
(B) Treatment of commissions. The term de minimis costs does not
include commissions paid to facilitate the acquisition of an intangible
described in paragraphs (c)(1)(i) through (v) of this section or to
facilitate the creation or origination of an intangible described in
paragraphs (d)(2)(i)(A) through (E) of this section.
(C) Average cost pooling method. A taxpayer may elect to establish
one or more pools of similar transactions for purposes of determining
the amount of transaction costs paid with respect to a transaction.
Under this pooling method, the amount of transaction costs paid with
respect to each transaction included in the pool is equal to the
average transaction costs paid with respect to all transactions
included in the pool. A taxpayer computes the average transaction costs
paid with respect to all transactions included in the pool by dividing
the sum of all transaction costs paid with respect to all transactions
included in the pool by the number of transactions included in the
pool. See paragraph (h) of this section for additional rules relating
to pooling.
(4) Special rules applicable to certain trade or business
acquisition and reorganization transactions--(i) Acquisitive
transactions--(A) In general. Except as provided in paragraph
(e)(4)(i)(B) of this section, in the case of an acquisition of a trade
or business (whether structured as an acquisition of stock or of assets
and whether the taxpayer is the acquirer in the acquisition or the
target of the acquisition), an amount paid in the process of pursuing
the acquisition facilitates the acquisition within the meaning of this
paragraph (e) only if the amount relates to activities performed on or
after the earlier of--
(1) The date on which the acquirer submits to the target a letter
of intent, offer letter, or similar written communication proposing a
merger, acquisition, or other business combination; or
(2) The date on which an acquisition proposal is approved by the
taxpayer's Board of Directors (or committee of the Board of Directors)
or, in the case of a taxpayer that is not a corporation, the date on
which the acquisition proposal is approved by the appropriate governing
officials of the taxpayer.
(B) Inherently facilitative amounts. An amount paid in the process
of pursuing an acquisition facilitates that acquisition if the amount
is inherently facilitative, regardless of whether the amount is paid
for activities performed prior to the date determined under paragraph
(e)(4)(i)(A) of this section. An amount is inherently facilitative if
the amount is paid for activities performed in determining the value of
the target, negotiating or structuring the transaction, preparing and
reviewing transactional documents, preparing and reviewing regulatory
filings required by the transaction, obtaining regulatory approval of
the transaction, securing advice on the tax consequences of the
transaction, securing an opinion as to the fairness of the transaction,
obtaining shareholder approval of the transaction, or conveying
property between the parties to the transaction.
(C) Success-based fees. An amount paid that is contingent on the
successful closing of an acquisition is an amount paid to facilitate
the acquisition except to the extent that evidence clearly demonstrates
that some portion of the amount is allocable to activities that do not
facilitate the acquisition.
(D) Integration costs. An amount paid to integrate the business
operations of the acquirer and the target does not facilitate the
acquisition within the meaning of paragraph (e)(1)(i) of this section,
regardless of when the integration activities occur.
(ii) Divisive transactions--(A) Stock distributions. An amount paid
to facilitate a distribution of stock to the shareholders of a taxpayer
is not required to be capitalized under this section if the divestiture
is required by law, regulatory mandate, or court order unless the
divestiture itself facilitates another transaction referred to in
paragraph (e)(1)(i) of this section. For example, where a taxpayer, to
comply with a new law requiring the taxpayer to divest itself of a
particular trade or business, contributes that trade or business to a
new subsidiary and distributes the stock of the subsidiary to the
taxpayer's shareholders, amounts paid to facilitate the distribution do
not facilitate a transaction referred to in paragraph (e)(1)(i) of this
section and are not required to be capitalized under this section.
Conversely, where a taxpayer, to secure regulatory approval for its
proposed acquisition of a target corporation, complies with a
government mandate to divest itself of a particular trade or business
and contributes the trade or business to a new subsidiary and
distributes the stock of the subsidiary to the taxpayer's shareholders,
amounts paid to facilitate the divestiture are amounts paid to
facilitate the acquisition of the target and must be capitalized under
this section.
(B) Taxable asset sales. An amount paid to facilitate the sale of
assets in a transaction not described in section 368 is not required to
be capitalized under this section unless the sale is required by law,
regulatory mandate, or court order and the sale itself facilitates
another transaction referred to in paragraph (e)(1)(i) of this section.
For example, where a target corporation, in preparation for a merger
with an acquirer, sells assets that are not desired by the acquirer,
amounts paid to facilitate the sale are not required to be capitalized
as amounts paid to facilitate the merger. Conversely, where a taxpayer,
in order to secure regulatory approval for its proposed acquisition of
a target corporation, complies with a government mandate to divest
itself of a particular trade or business and sells the assets of that
trade or business in a taxable sale, amounts paid to facilitate the
sale are amounts paid to facilitate the acquisition of the target and
must be capitalized under this section.
(iii) Defense against a hostile acquisition attempt--(A) In
general. An amount paid to defend against an acquisition of the
taxpayer in a hostile acquisition attempt is not an amount paid to
facilitate a transaction within the meaning of paragraph (e)(1)(i) of
this section. In determining whether an acquisition attempt is hostile,
all relevant facts and circumstances are
[[Page 77718]]
taken into account. The mere fact that the taxpayer receives an
unsolicited offer from a potential acquirer, or rejects an initial
offer from a potential acquirer, is not determinative of whether an
acquisition attempt is hostile. On the other hand, the fact that the
taxpayer implements defensive measures in response to the acquisition
attempt is evidence that the acquisition attempt is hostile. Once an
acquisition attempt ceases to be hostile, an amount paid by the
taxpayer in the process of pursuing the acquisition of its stock by the
acquirer is an amount paid to facilitate a transaction referred to in
paragraph (e)(1)(i) of this section.
(B) Exception for amounts paid to facilitate another capital
transaction. An amount paid to defend against an acquisition of the
taxpayer in a hostile acquisition attempt does not include a payment
that, while intended to thwart a hostile acquisition attempt by an
acquirer, itself facilitates another transaction referred to in
paragraph (e)(1)(i) of this section. Thus, for example, an amount paid
to effect a recapitalization in an effort to defend against a hostile
acquisition attempt is not an amount paid to defend against an
acquisition of the taxpayer in a hostile acquisition attempt for
purposes of paragraph (e)(4)(iii)(A) of this section.
(5) Coordination with paragraph (d) of this section. In the case of
an amount paid to facilitate the creation or enhancement of an
intangible described in paragraph (d) of this section, the provisions
of this paragraph (e) apply regardless of whether a payment described
in paragraph (d) is made.
(6) Application to stock issuance costs of open-end regulated
investment companies. Amounts paid by an open-end regulated investment
company (within the meaning of section 851) to facilitate an issuance
of its stock are treated as amounts that do not facilitate a
transaction referred to in paragraph (e)(1)(i) of this section unless
such amounts are paid during the initial stock offering period.
(7) Examples. The following examples illustrate the rules of this
paragraph (e):
Example 1. Costs to facilitate. In December 2002, R
corporation, a calendar year taxpayer, enters into negotiations with
X corporation to lease commercial property from X for a period of 25
years. R pays A, its outside legal counsel, $4,000 in December 2002
for services rendered by A during December in assisting with
negotiations with X. In January 2003, R and X finalize the terms of
the lease and execute the lease agreement. R pays B, another of its
outside legal counsel, $2,000 in January 2003 for services rendered
by B during January in drafting the lease agreement. The agreement
between R and X is an agreement providing R the right to use
property, as described in paragraph (d)(6)(i)(A) of this section.
R's payments to its outside counsel are amounts paid to facilitate
the creation of the agreement. As provided in paragraph
(e)(3)(ii)(A) of this section, R must aggregate its transaction
costs for purposes of determining whether the transaction costs are
de minimis. Because R's aggregate transaction costs exceed $5,000,
R's transaction costs are not de minimis costs within the meaning of
paragraph (e)(3)(ii)(A) of this section. Accordingly, R must
capitalize the $4,000 paid to A and the $2,000 paid to B under
paragraph (b)(1)(ii) of this section.
Example 2. Costs to facilitate. Q corporation pays its outside
counsel $20,000 to assist Q in registering its stock with the
Securities and Exchange Commission. Q is not a regulated investment
company within the meaning of section 851. Q's payments to its
outside counsel are amounts paid to facilitate the issuance of
stock. Accordingly, Q must capitalize its $20,000 payment under
paragraph (b)(1)(iii) of this section.
Example 3. Costs to facilitate. Partnership X leases its
manufacturing equipment from Y corporation under a 10-year lease.
During 2002, when the lease has a remaining term of 4 years, X
enters into a written agreement with Z corporation, a competitor of
Y, under which X agrees to lease its manufacturing equipment from Z,
subject to the condition that X first successfully terminates its
lease with Y. X pays Y $50,000 in exchange for Y's agreement to
terminate the equipment lease. Because the new lease is expressly
conditioned on the termination of the old lease agreement, as
provided in paragraph (e)(1)(ii) of this section, X's payment of
$50,000 facilitates the creation of a new lease. Accordingly, X must
capitalize the $50,000 termination payment under paragraph
(b)(1)(ii) of this section.
Example 4. Costs to facilitate. W corporation enters into a
lease agreement with X corporation under which W agrees to lease
property to X for a period of 5 years. W pays its outside counsel
$7,000 for legal services rendered in drafting the lease agreement
and negotiating with X. The agreement between W and X is an
agreement providing W the right to be compensated for the use of
property, as described in paragraph (d)(6)(i)(A) of this section.
Under paragraph (e)(1)(i) of this section, W's payment to its
outside counsel is an amount paid to facilitate W's creation of an
intangible asset. As provided by paragraph (e)(5) of this section, W
must capitalize its $7,000 payment to outside counsel
notwithstanding the fact that W made no payment described in
paragraph (d)(6)(i) of this section to induce X to enter into the
agreement.
Example 5. Costs to facilitate. Q corporation seeks to acquire
all of the outstanding stock of Y corporation. To finance the
acquisition, Q must issue new debt. Q pays an investment banker
$25,000 to market the debt to the public and pays its outside
counsel $10,000 to prepare the offering documents for the debt. Q's
payment of $35,000 facilitates a borrowing and must be capitalized
under paragraph (b)(1)(iii) of this section. As provided in
paragraph (e)(1)(iii) of this section, Q's payment does not
facilitate the acquisition of Y, notwithstanding the fact that Q
incurred the new debt to finance its acquisition of Y.
Example 6. Costs that do not facilitate. X corporation brings a
legal action against Y corporation to recover lost profits resulting
from Y's alleged infringement of X's copyright. Y does not challenge
X's copyright, but argues that it did not infringe upon X's
copyright. X pays its outside counsel $25,000 for legal services
rendered in pursuing the suit against Y. Because X's title to its
copyright is not in question, X's action against Y does not involve
X's defense or perfection of title to intangible property. Thus, the
amount paid to outside counsel does not facilitate the creation or
enhancement of an intangible asset described in paragraph (d)(9) of
this section. In addition, the amount paid to outside counsel does
not facilitate the acquisition, creation, or enhancement of any
other intangible asset described in this section. Accordingly, X is
not required to capitalize its $25,000 payment under this section.
Example 7. De minimis rule. W corporation, a commercial bank,
acquires a portfolio containing 100 loans from Y corporation. W pays
an independent agent a commission of $10,000 for brokering the
acquisition. The commission is an amount paid to facilitate W's
acquisition of an intangible asset. The acquisition of the loan
portfolio is a single transaction within the meaning of paragraph
(e)(2) of this section. Because the amounts paid to facilitate the
transaction exceed $5,000, the amounts are not de minimis as defined
in paragraph (e)(3)(ii)(A) of this section. Accordingly, W must
capitalize the $10,000 commission under paragraph (b)(1)(ii) of this
section.
Example 8. Compensation and overhead. P corporation, a
commercial bank, maintains a loan acquisition department whose sole
function is to acquire loans from other financial institutions. As
provided in paragraph (e)(3)(i) of this section, P is not required
to capitalize any portion of the compensation paid to the employees
in its loan acquisition department or any portion of its overhead
allocable to the loan acquisition department.
Example 9. Corporate acquisition. (i) On February 1, 2002, R
corporation decides to investigate the acquisition of three
potential targets: T corporation, U corporation, and V corporation.
R's consideration of T, U, and V represents the consideration of
three distinct transactions, any or all of which R might consummate.
On March 1, 2002, R issues a letter of intent to T and stops
pursuing U and V. On July 1, 2002, R acquires the stock of T in a
transaction described in section 368. R pays $1,000,000 to an
investment banker and $50,000 to its outside counsel to conduct due
diligence on the targets, determine the value of T, U, and V,
negotiate and structure the transaction with T, draft the merger
agreement, secure shareholder approval, prepare SEC filings, and
obtain the necessary regulatory approvals.
(ii) Under paragraph (e)(4)(i)(A) of this section, the amounts
paid to conduct due diligence on T, U and V prior to March 1, 2002
(the date of the letter of intent) are not amounts paid to
facilitate the acquisition of the stock of T and are not required to
be
[[Page 77719]]
capitalized under this paragraph (e). However, the amounts paid to
conduct due diligence on T on and after March 1, 2002, are amounts
paid to facilitate the acquisition of the stock of T and must be
capitalized under paragraph (b)(1)(ii) of this section.
(iii) Under paragraph (e)(4)(i)(B) of this section, the amounts
paid to determine the value of T, negotiate and structure the
transaction with T, draft the merger agreement, secure shareholder
approval, prepare SEC filings, and obtain necessary regulatory
approvals are inherently facilitative amounts paid to facilitate the
acquisition of the stock of T and must be capitalized, regardless of
whether those activities occur prior to March 1, 2002.
(iv) Under paragraph (e)(4)(i)(B) of this section, the amounts
paid to determine the value of U and V are inherently facilitative
amounts paid to facilitate the acquisition of U or V and must be
capitalized. However, these fees may be recovered under section 165
in the taxable year that R abandons the planned mergers with U and
V.
Example 10. Corporate acquisition; employee bonus. Assume the
same facts as in Example 9, except R pays a bonus of $10,000 to one
of its corporate officers who negotiated the acquisition of T. As
provided by paragraph (e)(3)(i) of this section, Y is not required
to capitalize any portion of the bonus paid to the corporate
officer.
Example 11. Corporate acquisition; integration costs. Assume the
same facts as in Example 9, except that, before and after the
acquisition is consummated, R incurs costs to relocate personnel and
equipment, provide severance benefits to terminated employees,
integrate records and information systems, prepare new financial
statements for the combined entity, and reduce redundancies in the
combined business operations. Under paragraph (e)(4)(i)(D) of this
section, these costs do not facilitate the acquisition of T.
Accordingly, R is not required to capitalize any of these costs
under this section.
Example 12. Corporate acquisition; compensation to target's
employees. Assume the same facts as in Example 9, except that, prior
to the acquisition, certain employees of T held unexercised options
issued pursuant to T's incentive stock option plan. These options
granted the employees the right to purchase T stock at a fixed
option price. The options did not have a readily ascertainable value
(within the meaning of Sec. 1.83-7(b)), and thus no amount was
included in the employees' income when the options were granted. As
a condition of the acquisition, T is required to terminate its
incentive stock option plan. T therefore agrees to pay its employees
who hold unexercised stock options the difference between the option
price and the current value of T's stock in consideration of their
agreement to cancel their unexercised options. Under paragraph
(e)(3)(i) of this section, T is not required to capitalize the
amounts paid to its employees.
Example 13. Corporate acquisition; retainer. Y corporation's
outside counsel charges Y $60,000 for services rendered in
facilitating the friendly acquisition of the stock of Y corporation
by X corporation. Y has an agreement with its outside counsel under
which Y pays an annual retainer of $50,000. Y's outside counsel has
the right to offset amounts billed for any legal services rendered
against the annual retainer. Pursuant to this agreement, Y's outside
counsel offsets $50,000 of the legal fees from the acquisition
against the retainer and bills Y for the balance of $10,000. The
$60,000 legal fee is an amount paid to facilitate the reorganization
of Y as described in paragraph (e)(1)(i) of this section. Y must
capitalize the full amount of the $60,000 legal fee.
Example 14. Corporate acquisition; antitrust defense costs. On
March 1, 2002, V corporation enters into an agreement with X
corporation to acquire all of the outstanding stock of X. On April
1, 2002, federal and state regulators file suit against V to prevent
the acquisition of X on the ground that the acquisition violates
antitrust laws. V enters into a consent agreement with regulators on
May 1, 2002, that allows the acquisition to proceed, but requires V
to hold separate the business operations of X pending the outcome of
the antitrust suit and subjects V to possible divestiture. V
acquires title to all of the outstanding stock of X on June 1, 2002.
After June 1, 2002, the regulators pursue antitrust litigation
against V seeking rescission of the acquisition. V pays $50,000 to
its outside counsel for services rendered after June 1, 2002, to
defend against the antitrust litigation. V ultimately prevails in
the antitrust litigation. V's costs to defend the antitrust
litigation are costs to facilitate its acquisition of the stock of X
under paragraph (e)(1)(i) of this section and must be capitalized.
Although title to the shares of X passed to V prior to the date V
incurred costs to defend the antitrust litigation, the amounts paid
by V are paid in the process of pursuing the acquisition of the
stock of X because the acquisition was not complete until the
antitrust litigation was ultimately resolved. Because the amounts
paid to defend the suit are not de minimis costs within the meaning
of paragraph (e)(3)(ii)(A) of this section, V must capitalize the
full $50,000.
Example 15. Corporate acquisition; hostile defense costs. (i) Y
corporation, a publicly traded corporation, becomes the target of a
hostile takeover attempt by Z corporation on January 15, 2002. In an
effort to defend against the takeover, Y pays legal fees to seek an
injunction against the takeover and investment banking fees to
locate a potential ``white knight'' acquirer, as well as costs to
effect a recapitalization. Y's efforts to enjoin the takeover and
locate a white knight acquirer are unsuccessful, and on March 15,
2002, Y's Board of Directors decides to abandon its defense against
the takeover and negotiate with Z in an effort to obtain the highest
possible price for its shareholders. After Y abandons its defense
against the takeover, Y pays its investment bankers $1,000,000 for a
fairness opinion and for services rendered in negotiating with Z.
(ii) Under paragraph (e)(4)(iii)(A) of this section, the legal
fees paid by Y to seek an injunction against the takeover and the
investment banking fees paid to search for a white knight acquirer
do not facilitate the acquisition of Y by Z. Such amounts are paid
to defend against Z's hostile takeover attempt and are not required
to be capitalized under this section.
(iii) Under paragraph (e)(4)(iii)(B) of this section, the
amounts paid by Y to effect a recapitalization are not amounts paid
to defend against a hostile acquisition attempt. Accordingly, the
amounts paid to effect the recapitalization must be capitalized
under paragraph (b)(1)(iii) of this section.
(iv) The $1,000,000 paid to the investment bankers after Y
abandons its defense against the takeover is an amount paid to
facilitate an acquisition of Y and must be capitalized under
paragraph (b)(1)(iii) of this section.
Example 16. Corporate acquisition; break up fees. (i) N
corporation enters into an agreement with U corporation under which
U agrees to purchase all of the outstanding stock of N for $70 per
share. The agreement between N and U provides that if the
acquisition does not succeed, N will pay U $1,000,000 as a break up
fee. Prior to the closing of the acquisition, N enters into an
agreement with W under which W agrees to purchase all of the
outstanding stock of N for $80 per share on the condition that N
terminates its pending acquisition agreement with U. N pays U
$1,000,000 to terminate the acquisition agreement and N subsequently
is acquired by W. Under paragraph (e)(1)(ii) of this section, the
$1,000,000 paid to U is an amount paid to facilitate a transaction
described in paragraph (b)(1)(iii) of this section. Accordingly, N
must capitalize the $1,000,000 payment.
Example 17. Corporate acquisition; break up fees to white
knight. Z corporation launches an unsolicited hostile tender offer
of $70 per share for 55 percent of the outstanding shares of T
corporation. In an effort to defend against a takeover by Z, T
enters into an agreement with W corporation, a ``white knight''
acquirer, under which W agrees to pay $75 per share for all
outstanding shares of T if T agrees to recommend the transaction to
its shareholders. The agreement between T and W provides that if the
acquisition of T by W does not succeed, T will pay W $1,000,000 as a
break up fee. Prior to the acquisition of T by W, Z amends its offer
to $85 per share for all of the outstanding shares of T. T's Board
of Directors concludes that Z's amended offer is preferable and
recommends that its shareholders accept Z's amended offer. Z
subsequently acquires all of the outstanding shares of T for $85 per
share. In accordance with its agreement with W, T pays W $1,000,000
to terminate the acquisition agreement. The $1,000,000 paid to W
does not facilitate Z's acquisition of the outstanding shares of T.
Under paragraph (e)(1)(ii) of this section, T's payment to W is not
made pursuant to an agreement under which the acquisition of the
outstanding shares of T by Z is expressly conditioned on the
termination of the agreement between T and W.
(f) 12-month rule--(1) In general--(i) Amounts paid to create or
enhance an intangible asset. A taxpayer is not required to capitalize
amounts paid to create or enhance an intangible asset if the amounts do
not create or enhance any right or benefit for the taxpayer that
extends beyond the earlier of--
[[Page 77720]]
(A) 12 months after the first date on which the taxpayer realizes
the right or benefit; or
(B) The end of the taxable year following the taxable year in which
the payment is made.
(ii) Transaction costs. A taxpayer is not required to capitalize
amounts paid to facilitate the creation or enhancement of an intangible
asset if, by reason of paragraph (f)(1)(i) of this section,
capitalization would not be required for amounts paid to create or
enhance that intangible asset.
(2) Duration of benefit for contract terminations. For purposes of
this paragraph (f), amounts paid to terminate a contract or other
agreement described in paragraph (d)(7)(i) of this section prior to its
expiration date (or amounts paid to facilitate such termination) create
a benefit for the taxpayer equal to the unexpired term of the agreement
as of the date of the termination.
(3) Inapplicability to created financial interests and self-created
amortizable section 197 intangibles. Paragraph (f)(1) of this section
does not apply to amounts paid to create or enhance an intangible
described in paragraph (d)(2) of this section (relating to amounts paid
to create or enhance financial interests) or to amounts paid to create
or enhance an intangible asset that constitutes an amortizable section
197 intangible within the meaning of section 197(c).
(4) Inapplicability to rights of indefinite duration. Paragraph
(f)(1) of this section does not apply to amounts paid to create or
enhance a right of indefinite duration. A right has an indefinite
duration if it has no period of duration fixed by agreement or by law,
or if it is not based on a period of time, such as a right attributable
to an agreement to provide or receive a fixed amount of goods or
services. For example, a license granted by a governmental agency that
permits the taxpayer to operate a business conveys a right of
indefinite duration if the license may be revoked only upon the
taxpayer's violation of the terms of the license.
(5) Rights subject to renewal--(i) In general. For purposes of
paragraph (f)(1)(i) of this section, the duration of a right includes
any renewal period if, based on all of the facts and circumstances in
existence during the taxable year in which the right is created, the
facts indicate a reasonable expectancy of renewal.
(ii) Reasonable expectancy of renewal. The following factors are
significant in determining whether there exists a reasonable expectancy
of renewal:
(A) Renewal history. The fact that similar rights are historically
renewed is evidence of a reasonable expectancy of renewal. On the other
hand, the fact that similar rights are rarely renewed is evidence of a
lack of a reasonable expectancy of renewal. Where the taxpayer has no
experience with similar rights, or where the taxpayer holds similar
rights only occasionally, this factor is less indicative of a
reasonable expectancy of renewal.
(B) Economics of the transaction. The fact that renewal is
necessary in order for the taxpayer to earn back its investment in the
right is evidence of a reasonable expectancy of renewal. For example,
if a taxpayer pays $10,000 to enter into a renewable contract with an
initial 9-month term that is expected to generate income to the
taxpayer of $1,000 per month, the fact that renewal is necessary in
order for the taxpayer to earn back its $10,000 inducement is evidence
of a reasonable expectancy of renewal.
(C) Likelihood of renewal by other party. Evidence that indicates a
likelihood of renewal by the other party to a right, such as a bargain
renewal option or similar arrangement, is evidence of a reasonable
expectancy of renewal. However, the mere fact that the other party will
have the opportunity to renew on the same terms as are available to
others, in a competitive auction or similar process that is designed to
reflect fair market value, is not evidence of a reasonable expectancy
of renewal.
(D) Terms of renewal. The fact that material terms of the right are
subject to renegotiation at the end of the initial term is evidence of
a lack of a reasonable expectancy of renewal. For example, if the
parties to an agreement must renegotiate price or amount, the
renegotiation requirement is evidence of a lack of a reasonable
expectancy of renewal.
(iii) Safe harbor pooling method. In lieu of applying the
reasonable expectancy of renewal test described in paragraph (f)(5)(ii)
of this section to each separate right created or enhanced during a
taxable year, a taxpayer may establish one or more pools of similar
rights for which the initial term does not extend beyond the period
described in paragraph (f)(1)(i) of this section and may apply the
reasonable expectancy of renewal test to each pool. See paragraph (h)
of this section for additional rules relating to pooling. The
application of paragraph (f)(1) of this section to each pool is
determined in the following manner:
(A) All amounts (except de minimis amounts described in paragraph
(d)(6)(ii) of this section) paid to create or enhance the rights
included in the pool and all amounts paid to facilitate the creation or
enhancement of the rights included in the pool are aggregated.
(B) If less than 20 percent of the rights in the pool are
reasonably expected to be renewed beyond the period prescribed in
paragraph (f)(1)(i) of this section, all rights in the pool are treated
as having a duration that does not extend beyond the period prescribed
in paragraph (f)(1)(i) of this section, and the taxpayer is not
required to capitalize under this section any portion of the aggregate
amount described in paragraph (f)(5)(iii)(A) of this section.
(C) If more than 80 percent of the rights in the pool are
reasonably expected to be renewed beyond the period prescribed in
paragraph (f)(1)(i) of this section, all rights in the pool are treated
as having a duration that extends beyond the period prescribed in
paragraph (f)(1)(i) of this section, and the taxpayer is required to
capitalize under this section the aggregate amount described in
paragraph (f)(5)(iii)(A) of this section.
(D) If 20 percent or more, but 80 percent or less, of the rights in
the pool are reasonably expected to be renewed beyond the period
prescribed in paragraph (f)(1)(i) of this section, the aggregate amount
described in paragraph (f)(5)(iii)(A) of this section is multiplied by
the percentage of the rights in the pool that are reasonably expected
to be renewed beyond the period prescribed in paragraph (f)(1)(i) of
this section and the taxpayer must capitalize the resulting amount
under this section by treating such amount as creating a separate
intangible asset.
(6) Rights terminable at will. A right is not described in
paragraph (f)(1)(i) of this section merely because the right is
terminable at will by either party. However, for purposes of paragraph
(f)(5) of this section, the fact that similar rights are typically
terminated prior to renewal is relevant in determining whether there
exists a reasonable expectancy of renewal for the right.
(7) Coordination with section 461. In the case of a taxpayer using
an accrual method of accounting, the rules of this paragraph (f) do not
affect the determination of whether a liability is incurred during the
taxable year, including the determination of whether economic
performance has occurred with respect to the liability. See Sec.
1.461-4(d) for rules relating to economic performance.
(8) Examples. The rules of this paragraph (f) are illustrated by
the following examples, in which it is assumed (unless otherwise
stated) that
[[Page 77721]]
the taxpayer is a calendar year, accrual method taxpayer:
Example 1. Prepaid expenses. On December 1, 2002, N corporation
pays a $10,000 insurance premium to obtain a property insurance
policy with a 1-year term that begins on February 1, 2003. The
amount paid by N is a prepaid expense described in paragraph (d)(3)
of this section. Because the right or benefit attributable to the
$10,000 payment extends beyond the end of the taxable year following
the taxable year in which the payment is made, the 12-month rule
provided by this paragraph (f) does not apply. N must capitalize the
$10,000 payment.
Example 2. Prepaid expenses. Assume the same facts as in Example
1, except that the policy has a term beginning on December 15, 2002.
The 12-month rule of this paragraph (f) applies to the $10,000
payment because the right or benefit attributable to the payment
neither extends more than 12 months beyond December 15, 2002 (the
first date the benefit is realized by the taxpayer) nor beyond the
taxable year following the year in which the payment is made.
Accordingly, N is not required to capitalize the $10,000 payment.
Example 3. Financial interests. On October 1, 2002, X
corporation makes a 9-month loan to B in the principal amount of
$250,000. The principal amount of the loan paid to B constitutes an
amount paid to create or originate a financial interest under
paragraph (d)(2)(i)(B) of this section. The 9-month term of the loan
does not extend beyond the period prescribed by paragraph (f)(1)(i)
of this section. However, as provided by paragraph (f)(3) of this
section, the rules of this paragraph (f) do not apply to intangibles
described in paragraph (d)(2) of this section. Accordingly, X must
capitalize the $250,000 loan amount.
Example 4. Financial interests. X corporation owns all of the
outstanding stock of Z corporation. On December 1, Y corporation, a
calendar year taxpayer, pays X $1,000,000 in exchange for X's grant
of a 9-month call option to Y permitting Y to purchase all of the
outstanding stock of Z. Y's payment to X constitutes an amount paid
to create or originate an option with X under paragraph
(d)(2)(i)(C)(7) of this section. The 9-month term of the option does
not extend beyond the period prescribed by paragraph (f)(1)(i) of
this section. However, as provided by paragraph (f)(3) of this
section, the rules of this paragraph (f) do not apply to intangibles
described in paragraph (d)(2) of this section. Accordingly, Y must
capitalize the $1,000,000 payment.
Example 5. License. (i) On July 1, 2002, R corporation pays
$10,000 to state X to obtain a license to operate a business in
state X for a period of 5 years. The terms of the license require R
to pay state X an annual fee of $500 due on July 1 of each of the
succeeding four years. R pays the $500 fee on July 1 of each
succeeding year as required by the license.
(ii) R's payment of $10,000 is an amount paid to a governmental
agency for a license granted by that agency to which paragraph
(d)(5) of this section applies. Because R's payment creates rights
or benefits for R that extend beyond the end of 2003 (the taxable
year following the taxable year in which the payment is made), the
rules of this paragraph (f) do not apply to R's payment.
Accordingly, R must capitalize the $10,000 payment.
(iii) R's payment of each $500 annual fee is a prepaid expense
described in paragraph (d)(3) of this section. R is not required to
capitalize the $500 fee in each of the succeeding four taxable
years. The rules of this paragraph (f) apply to each such payment
because each payment provides a right or benefit to R that does not
extend beyond 12 months after the first date on which R realizes the
rights or benefits attributable to the payment and does not extend
beyond the end of the taxable year following the taxable year in
which the payment is made.
Example 6. Lease. On December 1, 2002, W corporation, a calendar
year taxpayer, enters into a lease agreement with X corporation
under which W agrees to lease property to X for a period of 9
months, beginning on December 1, 2002. W pays its outside counsel
$7,000 for legal services rendered in drafting the lease agreement
and negotiating with X. The agreement between W and X is an
agreement providing W the right to be compensated for the use of
property, as described in paragraph (d)(6)(i)(A) of this section.
W's $7,000 payment to its outside counsel is an amount paid to
facilitate W's creation of an intangible asset as described in
paragraph (e)(1)(i) of this section. Under paragraph (f)(1)(ii) of
this section, W's payment to its outside counsel is not required to
be capitalized because, by reason of paragraph (f)(1)(i) of this
section (relating to the 12-month rule) an amount described in
paragraph (d)(6)(i)(A) of this section to create the agreement
between W and X would not be required to be capitalized under this
section.
Example 7. Certain contract terminations. V corporation owns
real property that it has leased to A for a period of 15 years. When
the lease has a remaining unexpired term of 5 years, V requests that
A agree to terminate the lease, enabling V to use the property in
its trade or business. V pays A $100,000 in exchange for A's
agreement to terminate the lease. V's payment to A to terminate the
lease is described in paragraph (d)(7)(i)(A) of this section. Under
paragraph (f)(2) of this section, V's payment creates a benefit for
V with a duration of 5 years, the remaining unexpired term of the
lease as of the date of the termination. Because the benefit
attributable to the expenditure extends beyond 12 months after the
first date on which V realizes the rights or benefits attributable
to the payment and beyond the end of the taxable year following the
taxable year in which the payment is made, the rules of this
paragraph (f) do not apply to the payment. V must capitalize the
$100,000 payment.
Example 8. Certain contract terminations. Assume the same facts
as in Example 7, except the lease is terminated when it has a
remaining unexpired term of 10 months. Under paragraph (f)(2) of
this section, V's payment creates a benefit for V with a duration of
10 months. The 12-month rule of this paragraph (f) applies to the
payment because the benefit attributable to the payment neither
extends more than 12 months beyond the date of termination (the
first date the benefit is realized by V) nor beyond the taxable year
following the year in which the payment is made. Accordingly, V is
not required to capitalize the $100,000 payment.
Example 9. Certain contract terminations. M corporation enters
into a 5-year agreement with X corporation under which X is required
to provide M with services over the term of the agreement. Under the
terms of the agreement, either M or X may terminate the agreement
without cause upon 30 days notice. M pays C, an individual, a
$10,000 commission for services provided by C in locating X and
bringing the parties together. The agreement between M and X is an
agreement providing M the right to acquire services as described in
paragraph (d)(6)(i)(B) of this section. M's $10,000 payment to C is
an amount paid to facilitate the creation of an intangible asset as
described in paragraph (e)(1)(i) of this section. Because the
duration of the contract is 5 years, the 12-month rule contained in
paragraph (f)(1)(i) of this section does not apply, notwithstanding
the fact that the agreement is terminable by either party without
cause upon 30 days notice. M must capitalize the $10,000 commission
payment.
Example 10. Coordination with section 461. (i) U corporation
leases office space from W corporation at a monthly rental rate of
$2,000. On December 31, 2002, U prepays its office rent expense for
the first six months of 2003 in the amount of $12,000. For purposes
of this example, it is assumed that the recurring item exception
provided by Sec. 1.461-5 does not apply and that the lease between
W and U is not a section 467 rental agreement as defined in section
467(d).
(ii) Under Sec. 1.461-4(d)(3), U's prepayment of rent is a
payment for the use of property by U for which economic performance
occurs ratably over the period of time U is entitled to use the
property. Accordingly, because economic performance with respect to
U's prepayment of rent does not occur until 2003, U's prepaid rent
is not incurred in 2002 and therefore is not properly taken into
account through capitalization, deduction, or otherwise in 2002.
Thus, the rules of this paragraph (f) do not apply to U's prepayment
of its rent.
(iii) Alternatively, assume that U uses the cash method of
accounting and the economic performance rules in Sec. 1.461-4
therefore do not apply to U. The 12-month rule of this paragraph (f)
applies to the $12,000 payment because the rights or benefits
attributable to U's prepayment of its rent do not extend beyond
December 31, 2003. Accordingly, U is not required to capitalize its
prepaid rent.
Example 11. Coordination with section 461. N corporation pays R
corporation, an advertising and marketing firm, $40,000 on August 1,
2002, for advertising and marketing services to be provided to N
throughout calendar year 2003. For purposes of this example, it is
assumed that the recurring item exception provided by Sec. 1.461-5
does not apply. Under Sec. 1.461-4(d)(2), N's payment arises out of
the provision of services to N by R for which economic performance
occurs as the services are provided. Accordingly, because economic
performance with respect to N's prepaid
[[Page 77722]]
advertising expense does not occur until 2003, N's prepaid
advertising expense is not incurred in 2002 and therefore is not
properly taken into account through capitalization, deduction, or
otherwise in 2002. Thus, the rules of this paragraph (f) do not
apply to N's payment.
(g) Treatment of capitalized transaction costs--(1) Costs described
in paragraph (b)(1)(i) or (ii) of this section. Except in the case of
amounts paid by an acquirer to facilitate an acquisition of stock or
assets in a transaction described in section 368, an amount required to
be capitalized by paragraph (b)(1)(i) or (ii) of this section is
capitalized to the basis of the intangible asset acquired, created, or
enhanced.
(2) Costs described in paragraph (b)(1)(iii) of this section--(i)
Stock issuance or recapitalization. An amount paid to facilitate a
stock issuance or a recapitalization is not capitalized to the basis of
an intangible asset but is treated as a reduction of the proceeds from
the stock issuance or the recapitalization.
(ii) [Reserved].
(h) Special rules applicable to pooling--(1) In general. The rules
of this paragraph (h) apply to the pooling methods described in
paragraph (d)(6)(ii) of this section (relating to de minimis rules
applicable to certain contract rights), paragraph (e)(3)(ii)(C) of this
section (relating to de minimis rules applicable to transaction costs),
and paragraph (f)(5)(iii) of this section (relating to the application
of the 12-month rule to renewable rights).
(2) Election to use pooling. An election to use a pooling method
identified in paragraph (h)(1) of this section for any taxable year is
made by establishing one or more pools for the taxable year in
accordance with the rules governing the particular pooling method and
the rules prescribed by this paragraph (h). An election to use a
pooling method identified in paragraph (h)(1) of this section is
irrevocable with respect to each pool established during the taxable
year.
(3) Definition of pool. A taxpayer may use any reasonable method of
defining a pool of similar transactions, agreements, or rights,
including a method based on the type of customer or the type of product
provided under a contract. However, a taxpayer that elects to pool
similar transactions, agreements, or rights must include in the pool
all similar transactions, agreements, or rights arising during the
taxable year.
(4) Consistency requirement. A taxpayer that uses the pooling
method described in paragraph (f)(5)(iii) of this section for purposes
of applying the 12-month rule to a right or benefit--
(i) Must use the pooling methods described in paragraph (d)(6)(ii)
of this section (relating to de minimis rules applicable to
inducements) and paragraph (e)(3)(ii)(C) of this section (relating to
de minimis applicable to transaction costs) for purposes of determining
the amount paid to create, or facilitate the creation of, the right or
benefit; and
(ii) Must use the same pool for purposes of paragraph (d)(6)(ii) of
this section and paragraph (e)(3)(ii)(C) of this section as is used for
purposes of paragraph (f)(5)(iii) of this section.
(i) [Reserved].
(j) Application to accrual method taxpayers. For purposes of this
section, the terms amount paid and payment mean, in the case of a
taxpayer using an accrual method of accounting, a liability incurred
(within the meaning of Sec. 1.446-1(c)(1)(ii)). A liability may not be
taken into account under this section prior to the taxable year during
which the liability is incurred.
(k) Treatment of related parties and indirect payments. For
purposes of this section, references to a party other than the taxpayer
include persons related to that party and persons acting for or on
behalf of that party. Persons are related for purposes of this section
only if their relationship is described in section 267(b) or 707(b) or
they are engaged in trades or businesses under common control within
the meaning of section 41(f)(1).
(l) Examples. The following examples illustrate the rules of this
section:
Example 1. License granted by a governmental unit. (i) X
corporation pays $25,000 to state R to obtain a license to sell
alcoholic beverages in its restaurant. The license is valid
indefinitely, provided X complies will all applicable laws regarding
the sale of alcoholic beverages in state R. X pays its outside
counsel $4,000 for legal services rendered in preparing the license
application and otherwise representing X during the licensing
process. In addition, X determines that $2,000 of salaries paid to
its employees is allocable to services rendered by the employees in
obtaining the license.
(ii) X's payment of $25,000 is an amount paid to a governmental
unit to obtain a license granted by that agency, as described in
paragraph (d)(5)(i) of this section. The right has an indefinite
duration and constitutes an amortizable section 197 intangible.
Accordingly, the provisions of paragraph (f) of this section
(relating to the 12-month rule) do not apply to X's payment. X must
capitalize its $25,000 payment to obtain the license from state R.
(iii) As provided in paragraph (e)(3) of this section, X is not
required to capitalize employee compensation because such amounts
are treated as amounts that do not facilitate the acquisition,
creation, or enhancement of an intangible asset. Thus, X is not
required to capitalize the $2,000 of employee compensation allocable
to the transaction.
(iv) X's payment of $4,000 to its outside counsel is an amount
paid to facilitate the creation of an intangible asset, as described
in paragraph (e)(1)(i) of this section. Because X's transaction
costs do not exceed $5,000, X's transaction costs are de minimis
within the meaning of paragraph (e)(3)(ii)(A) of this section.
Accordingly, X is not required to capitalize the $4,000 payment to
its outside counsel under this section.
Example 2. Franchise agreement. (i) R corporation is a
franchisor of income tax return preparation outlets. V corporation
negotiates with R to obtain the right to operate an income tax
return preparation outlet under a franchise from R. V pays an
initial $100,000 franchise fee to R in exchange for the franchise
agreement. In addition, V pays its outside counsel $4,000 to
represent V during the negotiations with R. V also pays $2,000 to an
industry consultant to advise V during the negotiations with R.
(ii) Under paragraph (d)(6)(i)(A) of this section, V's payment
of $100,000 is an amount paid to another party to induce that party
to enter into an agreement providing V the right to use tangible or
intangible property. Accordingly, V must capitalize its $100,000
payment to R. The franchise agreement is an amortizable section 197
intangible within the meaning of section 197(c). Accordingly, as
provided in paragraph (f)(3) of this section, the 12-month rule
contained in paragraph (f)(1)(i) of this section does not apply.
(iii) V's payment of $4,000 to its outside counsel and $2,000 to
the industry consultant are amounts paid to facilitate the creation
of an intangible asset, as described in paragraph (e)(1)(i) of this
section. Because V's aggregate transaction costs exceed $5,000, V's
transaction costs are not de minimis within the meaning of paragraph
(e)(3)(ii)(A) of this section. Accordingly, V must capitalize the
$4,000 payment to its outside counsel and the $2,000 payment to the
industry consultant under this section into the basis of the
franchise, as provided in paragraph (g)(1) of this section.
Example 3. Covenant not to compete. (i) On December 1, 2002, N
corporation, a calendar year taxpayer, enters into a covenant not to
compete with B, a key employee that is leaving the employ of N. The
covenant not to compete prohibits B from competing with N for a
period of 9 months, beginning December 1, 2002. N pays B $50,000 in
full consideration for B's agreement not to compete. In addition, N
pays its outside counsel $6,000 to facilitate the creation of the
covenant not to compete with B.
(ii) Under paragraph (d)(6)(i)(C) of this section, N's payment
of $50,000 is an amount paid to another party to induce that party
to enter into a covenant not to compete with N. However, because the
covenant not to compete has a duration that does not extend beyond
12 months after the first date on which N realizes the rights
attributable to its payment (i.e., December 1, 2002), the 12-month
rule contained in paragraph (f)(1)(i) of
[[Page 77723]]
this section applies. Accordingly, N is not required to capitalize
its $50,000 payment to B. In addition, as provided in paragraph
(f)(1)(ii) of this section, N is not required to capitalize its
$6,000 payment to facilitate the creation of the covenant not to
compete.
Example 4. Corporate reorganization; initial public offering. Y
corporation is a privately-owned company. Y's Board of Directors
authorizes an initial public offering of Y's stock in order to fund
future growth. Y pays $5,000,000 in professional fees for investment
banking services related to the determination of the offering price
and legal services related to the development of the offering
prospectus and the registration and issuance of stock. Under
paragraph (b)(1)(iii) of this section, the $5,000,000 is an amount
paid to facilitate a transaction involving the acquisition of
capital. As provided in paragraph (g)(2)(i) of this section, Y must
treat the $5,000,000 as a reduction of the proceeds from the stock
issuance.
Example 5. Demand-side management. (i) X corporation, a public
utility engaged in generating and distributing electrical energy,
provides programs to its customers to promote energy conservation
and energy efficiency. These programs are aimed at reducing
electrical costs to X's customers, building goodwill with X's
customers, and reducing X's future operating and capital costs. X
provides these programs without obligating any of its customers
participating in the programs to purchase power from X in the
future. Under these programs, X pays a consultant to help industrial
customers design energy-efficient manufacturing processes, to
conduct ``energy efficiency audits'' that serve to identify for
customers inefficiencies in their energy usage patterns, and to
provide cash allowances to encourage residential customers to
replace existing appliances with more energy efficient appliances.
(ii) The amounts paid by X to the consultant are not amounts to
acquire, create, or enhance an intangible identified in paragraph
(c) or (d) of this section or to facilitate such an acquisition,
creation, or enhancement. In addition, the amounts do not create a
separate and distinct intangible asset within the meaning of
paragraph (b)(3) of this section. Accordingly, the amounts paid to
the consultant are not required to be capitalized under this
section. While the amounts may serve to reduce future operating and
capital costs and create goodwill with customers, these benefits,
without more, are not intangible assets for which capitalization is
required under this section unless the Internal Revenue Service
publishes guidance identifying these benefits as an intangible asset
for which capitalization is required.
Example 6. Business process re-engineering. (i) V corporation
manufactures its products using a batch production system. Under
this system, V continuously produces component parts of its various
products and stockpiles these parts until they are needed in V's
final assembly line. Finished goods are stockpiled awaiting orders
from customers. V discovers that this process ties up significant
amounts of V's capital in work-in-process and finished goods
inventories, and hires B, a consultant, to advise V on improving the
efficiency of its manufacturing operations. B recommends a complete
re-engineering of V's manufacturing process to a process known as
just-in-time manufacturing. Just-in-time manufacturing involves
reconfiguring a manufacturing plant to a configuration of ``cells''
where each team in a cell performs the entire manufacturing process
for a particular customer order, thus reducing inventory stockpiles.
(ii) V incurred three categories of costs to convert its
manufacturing process to a just-in-time system. First, V paid B, a
consultant, $250,000 in professional fees to implement the
conversion of V's plant to a just-in-time system. Second, V paid C,
a contractor, $100,000 to relocate and reconfigure V's manufacturing
equipment from an assembly line layout to a configuration of cells.
Third, V paid D, a consultant, $50,000 to train V's employees in the
just-in-time manufacturing process.
(iii) The amounts paid by V to B, C, and D are not amounts to
acquire, create, or enhance an intangible identified in paragraph
(c) or (d) of this section or to facilitate such an acquisition,
creation, or enhancement. In addition, the amounts do not create a
separate and distinct intangible asset within the meaning of
paragraph (b)(3) of this section. Accordingly, the amounts paid to
B, C, and D are not required to be capitalized under this section.
While the amounts produce long term benefits to V in the form of
reduced inventory stockpiles, improved product quality, and
increased efficiency, these benefits, without more, are not
intangible assets for which capitalization is required under this
section unless the Internal Revenue Service publishes guidance
identifying these benefits as an intangible asset for which
capitalization is required.
Example 7. Defense of business reputation. (i) X, an investment
adviser, serves as the fund manager of a money market investment
fund. X, like its competitors in the industry, strives to maintain a
constant net asset value for its money market fund of $1.00 per
share. During 2003, in the course of managing the fund assets, X
incorrectly predicts the direction of market interest rates,
resulting in significant investment losses to the fund. Due to these
significant losses, X is faced with the prospect of reporting a net
asset value that is less than $1.00 per share. X is not aware of any
investment adviser in its industry that has ever reported a net
asset value for its money market fund of less than $1.00 per share.
X is concerned that reporting a net asset value of less than $1.00
per share will significantly harm its reputation as an investment
adviser, and could lead to litigation by shareholders. X decides to
contribute $2,000,000 to the fund in order to raise the net asset
value of the fund to $1.00 per share. This contribution is not a
loan to the fund and does not give X any ownership interest in the
fund.
(ii) The $2,000,000 contribution is not an amount paid to
acquire, create, or enhance an intangible identified in paragraph
(c) or (d) of this section or to facilitate such an acquisition,
creation, or enhancement. In addition, the amount does not create a
separate and distinct intangible asset within the meaning of
paragraph (b)(3) of this section. Accordingly, the amount
contributed to the fund is not required to be capitalized under this
section. While the amount serves to protect the business reputation
of the taxpayer and may protect the taxpayer from litigation by
shareholders, these benefits, without more, are not intangible
assets for which capitalization is required under this section
unless the Internal Revenue Service publishes guidance identifying
these benefits as an intangible asset for which capitalization is
required.
(m) Amortization. For rules relating to amortization of certain
intangible assets, see Sec. 1.167(a)-3.
(n) Intangible interests in land. [Reserved].
(o) Effective Date--(1) In general. This section applies to amounts
paid or incurred on or after the date the final regulations are
published in the Federal Register.
(2) Automatic consent to change method of accounting. A taxpayer
seeking to change a method of accounting to comply with this section
must follow the applicable administrative procedures issued under Sec.
1.446-1(e)(3)(ii) for obtaining the Commissioner's automatic consent to
a change in accounting method (Revenue Procedure 2002-9 or its
successor). Any change in method of accounting to comply with this
section must be made using an adjustment under section 481(a). However,
for this purpose, the adjustment under section 481(a) is determined by
taking into account only amounts paid or incurred on or after the date
the final regulations are published in the Federal Register. The final
regulations may provide additional terms and conditions for changes
under this paragraph (o)(2).
Par. 4. Section 1.446-5 is added to read as follows:
Sec. 1.446-5 Debt issuance costs.
(a) In general. This section provides rules for allocating debt
issuance costs over the term of the debt. For purposes of this section,
the term debt issuance costs means those transaction costs incurred by
an issuer of debt (that is, a borrower) that are required to be
capitalized under Sec. 1.263(a)-4(e). If these costs are otherwise
deductible, they are deductible by the issuer over the term of the debt
as determined under paragraph (b) of this section.
(b) Method of allocating debt issuance costs--(1) In general.
Solely for purposes of determining the amount of debt issuance costs
that may be deducted in any period, these costs are treated as if they
adjusted the yield on the debt. To effect this, the issuer treats the
costs as if they decreased the issue price of the debt. See Sec.
1.1273-2 to
[[Page 77724]]
determine issue price. Thus, debt issuance costs increase or create
original issuance discount and decrease or eliminate bond issuance
premium.
(2) Original issue discount. Any resulting original issue discount
is taken into account by the issuer under the rules in Sec. 1.163-7,
which generally require the use of a constant yield method (as
described in Sec. 1.1272-1) to compute how much original issue
discount is deductible for a period. However, see Sec. 1.163-7(b) for
special rules that apply if the total original issue discount on the
debt is de minimis.
(3) Bond issuance premium. Any remaining bond issuance premium is
taken into account by the issuer under the rules of Sec. 1.163-13,
which generally require the use of a constant yield method for purposes
of allocating bond issuance premium to accrual periods.
(c) Example. The following example illustrates the rules of this
section:
Example. (i) On January 1, 2004, X borrows $10,000,000. The
principal amount of the loan ($10,000,000) is repayable on December
31, 2008, and payments of interest in the amount of $500,000 are due
on December 31 of each year the loan is outstanding. X incurs debt
issuance costs of $130,000 to facilitate the borrowing.
(ii) Under Sec. 1.1273-2, the issue price of the loan is
$10,000,000. However, under paragraph (b) of this section, X reduces
the issue price of the loan by the debt issuance costs of $130,000,
resulting in an issue price of $9,870,000. As a result, X treats the
loan as having original issue discount in the amount of $130,000
(stated redemption price at maturity of $10,000,000 minus the issue
price of $9,870,000). Because this amount of original issue discount
is more than a de minimis amount (within the meaning of Sec.
1.1273-1(d)), X must allocate the original issue discount to each
year based on the constant yield method described in Sec. 1.1272-
1(b). See Sec. 1.163-7(a). Based on this method and a yield of
5.30%, compounded annually, the original issue discount is allocable
to each year as follows: $23,385 for 2004, $24,625 for 2005, $25,931
for 2006, $27,306 for 2007, and $28,753 for 2008.
(d) Effective date. This section applies to debt issuance costs
incurred for debt instruments issued on or after the date final
regulations are published in the Federal Register.
(e) Accounting method changes--(1) Consent to change. An issuer
required to change its method of accounting for debt issuance costs to
comply with this section must secure the consent of the Commissioner in
accordance with the requirements of Sec. 1.446-1(e). Paragraph (e)(2)
of this section provides the Commissioner's automatic consent for
certain changes.
(2) Automatic consent. The Commissioner grants consent for an
issuer to change its method of accounting for debt issuance costs
incurred for debt instruments issued on or after the date final
regulations are published in the Federal Register. Because this change
is made on a cut-off basis, no items of income or deduction are omitted
or duplicated and, therefore, no adjustment under section 481 is
allowed. The consent granted by this paragraph (e)(2) applies
provided--
(i) The change is made to comply with this section;
(ii) The change is made for the first taxable year for which the
issuer must account for debt issuance costs under this section; and
(iii) The issuer attaches to its federal income tax return for the
taxable year containing the change a statement that it has changed its
method of accounting under this section.
David A. Mader,
Assistant Deputy Commissioner of Internal Revenue.
[FR Doc. 02-31859 Filed 12-18-02; 8:45 am]
BILLING CODE 4830-01-P