[Federal Register Volume 67, Number 16 (Thursday, January 24, 2002)]
[Proposed Rules]
[Pages 3461-3465]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-1678]


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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: Advance notice of proposed rulemaking.

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SUMMARY: This document describes and explains rules and standards that 
the IRS and Treasury Department expect to propose in 2002 in a notice 
of proposed rulemaking that will clarify the application of section 
263(a) of the Internal Revenue Code to expenditures incurred in 
acquiring, creating, or enhancing certain intangible assets or 
benefits. This document also invites comments from the public regarding 
these standards. All materials submitted will be available for public 
inspection and copying.

DATES: Written and electronic comments must be submitted by March 25, 
2002.

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 5 p.m. to: CC:ITA:RU (REG-125638-01), 
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW., 
Washington, DC. Alternatively, taxpayers may send submissions

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electronically via the Internet by selecting the ``Tax Regs'' option on 
the IRS Home Page, or directly to the IRS Internet site at http://
www.irs.ustreas.gov/tax__regs/regslist.html.

FOR FURTHER INFORMATION CONTACT: Concerning submissions, Guy Traynor 
(202) 622-7180; concerning the proposals, Andrew J. Keyso (202) 927-
9397 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: The IRS and Treasury Department are 
reviewing the application of section 263(a) of the Internal Revenue 
Code to expenditures that result in taxpayers acquiring, creating, or 
enhancing intangible assets or benefits. This document describes and 
explains rules and standards that the IRS and Treasury Department 
expect to propose in 2002 in a notice of proposed rulemaking.
    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 taxable years. See 
Commissioner v. Idaho Power Co., 418 U.S. 1, 16 (1974). Thus, the 
Supreme Court has held that expenditures that create or enhance 
separate and distinct assets or produce certain other future benefits 
of a significant nature must be capitalized under section 263(a). See 
INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992); Commissioner v. 
Lincoln Savings & Loan Ass'n, 403 U.S. 345 (1971).
    The difficulty of translating general capitalization principles 
into clear, consistent, and administrable standards has been recognized 
for decades. See Welch v. Helvering, 290 U.S. 111, 114-15 (1933). 
Because courts focus on particular facts before them, the results 
reached by the courts are often difficult to reconcile and, 
particularly in recent years, have contributed to substantial 
uncertainty and controversy. The IRS and Treasury Department are 
concerned that the current level of uncertainty and controversy is 
neither fair to taxpayers nor consistent with sound and efficient tax 
administration.
    Recently, much of the uncertainty and controversy in the 
capitalization area has related to expenditures that create or enhance 
intangible assets or benefits. To clarify the application of section 
263(a), the forthcoming notice of proposed rulemaking will describe the 
specific categories of expenditures incurred in acquiring, creating, or 
enhancing intangible assets or benefits that taxpayers are required to 
capitalize. In addition, the forthcoming notice of proposed rulemaking 
will recognize that many expenditures that create or enhance intangible 
assets or benefits do not create the type of future benefits for which 
capitalization under section 263(a) is appropriate, particularly when 
the administrative and record keeping costs associated with 
capitalization are weighed against the potential distortion of income.
    To reduce the administrative and compliance costs associated with 
section 263(a), the forthcoming notice of proposed rulemaking is 
expected to provide safe harbors and simplifying assumptions including 
a ``one-year rule,'' under which expenditures relating to intangible 
assets or benefits whose lives are of a relatively short duration are 
not required to be capitalized, and ``de minimis rules,'' under which 
certain types of expenditures less than a specified dollar amount are 
not required to be capitalized. The IRS and Treasury Department are 
also considering additional administrative relief, for example, by 
providing a ``regular and recurring rule,'' under which transaction 
costs incurred in transactions that occur on a regular and recurring 
basis in the routine operation of a taxpayer's trade or business are 
not required to be capitalized.
    The proposed standards and rules described in this document will 
not alter the manner in which provisions of the law other than section 
263(a) (e.g., sections 195, 263(g), 263(h), or 263A) apply to determine 
the correct tax treatment of an item. Moreover, these standards and 
rules will not address the treatment of costs other than those to 
acquire, create, or enhance intangible assets or benefits, such as 
costs to repair or improve tangible property. The IRS and Treasury 
Department are considering separate guidance to address these other 
costs.
    The following discussion describes the specific expenditures to 
acquire, create, or enhance intangible assets or benefits for which the 
IRS and Treasury Department expect to require capitalization in the 
forthcoming notice of proposed rulemaking. The IRS and Treasury 
Department anticipate that other expenditures to acquire, create, or 
enhance intangible assets or benefits generally will not be subject to 
capitalization under section 263(a).

A. Amounts Paid To Acquire Intangible Property

1. Amounts Paid To Acquire Financial Interests
    Under the expected regulations, capitalization will be required for 
an amount paid to purchase, originate, or otherwise acquire a security, 
option, any other financial interest described in section 197(e)(1), or 
any evidence of indebtedness. For a discussion of related transaction 
costs see section C of this document.
    For example, a financial institution that acquires portfolios of 
loans from another person or originates loans to borrowers would be 
required to capitalize the amounts paid for the portfolios or the 
amounts loaned to borrowers.
2. Amounts Paid To Acquire Intangible Property From Another Person
    Under the expected regulations, capitalization will be required for 
an amount paid to another person to purchase or otherwise acquire 
intangible property from that person. For a discussion of related 
transaction costs see section C of this document.
    For example, an amount paid to another person to acquire an 
amortizable section 197 intangible from that person would be 
capitalized. Thus, a taxpayer that acquires a customer base from 
another person would be required to capitalize the amount paid to that 
person in exchange for the customer base. On the other hand, a taxpayer 
that incurs costs to create its own customer base through advertising 
or other expenditures that create customer goodwill would not be 
required to capitalize such costs under this rule.

B. Amounts Paid To Create or Enhance Certain Intangible Rights or 
Benefits

1. 12-Month Rule
    The IRS and Treasury Department expect to propose a 12-month rule 
applicable to expenditures paid to create or enhance certain intangible 
rights or benefits. Under the rule, capitalization under section 263(a) 
would not be required for an expenditure described in the following 
paragraphs 2 through 8 unless that expenditure created or enhanced 
intangible rights or benefits for the taxpayer that extend beyond the 
earlier of (i) 12 months after the first date on which the taxpayer 
realizes the rights or benefits attributable to the expenditure, or 
(ii) the end of the taxable year following the taxable year in which 
the expenditure is incurred.
    The IRS and Treasury Department request comments on how the 12-
month rule might apply to expenditures paid to create or enhance rights 
of indefinite duration and contracts subject to termination provisions. 
For example, comments are requested on whether costs to create contract 
rights that are terminable at will without substantial

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penalties would not be subject to capitalization as a result of the 12-
month rule.
2. Prepaid Items
    Subject to the 12-month rule, the IRS and Treasury Department 
expect to propose a rule that requires capitalization of an amount 
prepaid for goods, services, or other benefits (such as insurance) to 
be received in the future.
    For example, a taxpayer that prepays the premium for a 3-year 
insurance policy would be required to capitalize such amount under the 
rule.
    Similarly, a calendar year taxpayer that pays its insurance premium 
on December 1, 2002, for a 12-month policy beginning the following 
February would be required to capitalize the amount of the expenditure. 
The 12-month rule would not apply because the benefit attributable to 
the expenditure would extend beyond the end of the taxable year 
following the taxable year in which the expenditure was incurred. On 
the other hand, if the insurance contract had a term beginning on 
December 15, 2002, the taxpayer could deduct the premium expenditure 
under the 12-month rule because the benefit 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 the expenditure was incurred.
3. Certain Market Entry Payments
    Subject to the 12-month rule, the IRS and Treasury Department 
expect to propose a rule that requires capitalization of an amount paid 
to an organization to obtain or renew a membership or privilege from 
that organization.
    For example, subject to the 12-month rule, the rule would require 
capitalization of costs to obtain a stock trading privilege, admission 
to practice medicine at a hospital, and access to the multiple listing 
service. The rule does not contemplate requiring capitalization for 
costs to obtain ISO 9000 certification or similar costs.
4. Amounts Paid To Obtain Certain Rights From a Governmental Agency
    Subject to the 12-month rule, the IRS and Treasury Department 
expect to propose a rule that requires capitalization of an amount paid 
to a governmental agency for a trade name, trademark, copyright, 
license, permit, or other right granted by that governmental agency.
    For example, under the rule, a restaurant would be required to 
capitalize the amount paid to a state to obtain a license to serve 
alcoholic beverages that is valid indefinitely.
5. Amounts Paid To Obtain or Modify Contract Rights
    Subject to the 12-month rule, the IRS and Treasury Department 
expect to propose a rule that requires capitalization of amounts in 
excess of a specified dollar amount (e.g., $5,000) paid to another 
person to induce that person to enter into, renew, or renegotiate an 
agreement that produces contract rights enforceable by the taxpayer, 
including payments for leases, covenants not to compete, licenses to 
use intangible property, customer contracts and supplier contracts. The 
IRS and Treasury Department request comments on whether there are 
standards other than the standard described above that would be more 
appropriate for determining whether expenditures related to the 
creation or enhancement of contractual rights should be capitalized.
    Subject to the 12-month rule, this rule would require a lessee to 
capitalize an amount paid to a lessor in exchange for the lessor's 
agreement to enter into a lease. This rule also would require a lessee 
to capitalize an amount paid to a lessor in exchange for the lessor's 
agreement to terminate a lease and enter into a new lease. See, e.g., 
U.S. Bancorp v. Commissioner, 111 T.C. 231 (1998). However, this rule 
would not require a lessee to capitalize an amount paid to a lessor to 
terminate a lease where the parties do not enter into a new or 
renegotiated agreement. This rule also would not require a taxpayer to 
capitalize a payment that does not create enforceable contract rights 
but, for example, merely creates an expectation that a customer or 
supplier will maintain its business relationship with the taxpayer. 
See, e.g., Van Iderstine Co. v. Commissioner, 261 F.2d 211 (2nd Cir. 
1958).
6. Amounts Paid To Terminate Certain Contracts
    Subject to the 12-month rule, the IRS and Treasury Department 
expect to propose a rule that requires capitalization of an amount paid 
by a lessor to a lessee to induce the lessee to terminate a lease of 
real or tangible personal property or by a taxpayer to terminate a 
contract that grants another person the exclusive right to conduct 
business in a defined geographic area.
    For example, under the rule, a lessor that pays a lessee to 
terminate a lease of real property with a remaining term of 24 months 
would be required to capitalize such payment. See, e.g., Peerless 
Weighing and Vending Machine Corp. v. Commissioner, 52 T.C. 850 (1969). 
On the other hand, if the lease had a remaining term of 6 months, the 
12-month rule would apply, and the taxpayer would not be required to 
capitalize the termination payment under the rule.
    As a further example, where a taxpayer grants another person the 
exclusive right to develop the taxpayer's motel chain in four states, 
and the taxpayer later pays that other person to terminate such right 
at a time when the remaining useful life of the right is 5 years, the 
taxpayer would be required to capitalize the termination payment under 
the rule. See Rodeway Inns of America v. Commissioner, 63 T.C. 414 
(1974).
7. Amounts Paid in Connection With Tangible Property Owned by Another
    Subject to the 12-month rule, the IRS and Treasury Department 
expect to propose a rule that requires capitalization of amounts in 
excess of a specified dollar amount paid to facilitate the acquisition, 
production, or installation of tangible property that is owned by a 
person other than the taxpayer where the acquisition, production, or 
installation of the tangible property results in the type of intangible 
future benefit to the taxpayer for which capitalization is appropriate. 
This rule would apply even though there is no contractual relationship 
between the taxpayer and the other person. This rule is intended to 
require capitalization of expenditures that produce intangible future 
benefits similar to those that were in issue in Kauai Terminal Ltd. v. 
Commissioner, 36 B.T.A. 893 (1937) (expenditure incurred to construct a 
publicly owned breakwater for the purpose of increasing taxpayer's 
freight lighterage operation). The IRS and Treasury Department request 
comments on standards that can be established to ensure that the 
expenditures described in this rule result in the type of future 
benefits that are similar to those in Kauai Terminal and therefore 
should be capitalized. The IRS and Treasury Department also request 
comments on whether safe harbors or dollar thresholds should be used to 
determine whether capitalization of such expenditures is appropriate 
under section 263(a).
8. Defense or Perfection of Title to Intangible Property
    Subject to the 12-month rule, the IRS and Treasury Department 
expect to propose a rule that requires capitalization of amounts paid 
to defend or perfect title to intangible property.

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    For example, under the rule, if a taxpayer and another person both 
claim title to a particular trademark, the taxpayer must capitalize any 
amount paid to the other person for relinquishment of such claim. See, 
e.g., J.J. Case Company v. United States, 32 F.Supp. 754 (Ct. Cl. 
1940).

C. Transaction Costs

    The IRS and Treasury Department expect to propose a rule that 
requires a taxpayer to capitalize certain transaction costs that 
facilitate the taxpayer's acquisition, creation, or enhancement of 
intangible assets or benefits described above (regardless of whether a 
payment described in sections A or B of this document is made). In 
addition, this rule would require a taxpayer to capitalize transaction 
costs that facilitate the taxpayer's acquisition, creation, 
restructuring, or reorganization of a business entity, an applicable 
asset acquisition within the meaning of section 1060(c), or a 
transaction involving the acquisition of capital, including a stock 
issuance, borrowing, or recapitalization. However, this rule would not 
require capitalization of employee compensation (except for bonuses and 
commissions that are paid with respect to the transaction), fixed 
overhead (e.g., rent, utilities and depreciation), or costs that do not 
exceed a specified dollar amount, such as $5,000. The IRS and Treasury 
Department request comments on how expenditures should be aggregated 
for purposes of applying the de minimis exception, whether the de 
minimis exception should allow a deduction for the threshold amount 
where the aggregate transaction costs exceed the threshold amount, and 
whether there are certain expenditures for which the de minimis 
exception should not apply (e.g., commissions).
    The IRS and Treasury Department are considering alternative 
approaches to minimize uncertainty and to ease the administrative 
burden of accounting for transaction costs. For example, the rules 
could allow a deduction for all employee compensation (including 
bonuses and commissions that are paid with respect to the transaction), 
be based on whether the transaction is regular or recurring, or follow 
the financial or regulatory accounting treatment of the transaction. 
The IRS and Treasury Department request comments on whether the 
recurring or nonrecurring nature of a transaction is an appropriate 
consideration in determining whether an expenditure to facilitate the 
transaction must be capitalized under section 263(a) and, if so, what 
criteria should be applied in distinguishing between recurring and 
nonrecurring transactions. In addition, the IRS and Treasury Department 
request comments on whether a taxpayer's treatment of transaction costs 
for financial or regulatory accounting purposes should be taken into 
account when developing simplifying assumptions.
    For example, under the rule described above, a taxpayer would be 
required to capitalize legal fees in excess of the threshold dollar 
amount paid to its outside attorneys for services rendered in drafting 
a 3-year covenant not to compete because such costs facilitated the 
creation of the covenant not to compete. Similarly, the rule would 
require a taxpayer to capitalize legal fees in excess of the threshold 
dollar amount paid to its outside attorneys for services rendered in 
defending a trademark owned by the taxpayer.
    Conversely, a taxpayer that originates a loan to a borrower in the 
course of its lending business would not be required to capitalize 
amounts paid to secure a credit history and property appraisal to 
facilitate the loan where the total amount paid with respect to that 
loan does not exceed the threshold dollar amount. The taxpayer also 
would not be required to capitalize the amount of salaries paid to 
employees or overhead costs of the taxpayer's loan origination 
department.
    In addition, the rule would require a corporate taxpayer to 
capitalize legal fees in excess of the threshold dollar amount paid to 
its outside counsel to facilitate an acquisition of all of the 
taxpayer's outstanding stock by an acquirer. See, e.g., INDOPCO, Inc. 
v. Commissioner, 503 U.S. 79 (1992). However, the rule would not 
require capitalization of the portion of officers' salaries that is 
allocable to time spent by the officers negotiating the acquisition. 
Cf. Wells Fargo & Co. v. Commissioner, 224 F.3d 874 (8th Cir. 2000).
    The rule also would not require capitalization of post-acquisition 
integration costs or severance payments made to employees as a result 
of an acquisition transaction because such costs do not facilitate the 
acquisition.

D. Other Items on Which Public Comment is Requested

1. Other Costs of Creating, Acquiring or Enhancing Intangible Assets or 
Benefits That Require Capitalization
    The IRS and Treasury Department are considering what general 
principles of capitalization should be used to identify the costs of 
acquiring, creating, or enhancing intangible assets or benefits that 
should be capitalized under section 263(a) but are not described above. 
The IRS and Treasury Department anticipate that these general 
principles will apply in rare and unusual circumstances to require 
capitalization of costs that are similar to those described above. 
Comments are requested on capitalization principles (for example, a 
separate and distinct asset test or a significant future benefit test) 
that can be used to identify other costs that should be capitalized 
under section 263(a) and the administrability of such principles. The 
IRS and Treasury Department also request comments on other categories 
of costs associated with intangible assets or benefits that should be 
capitalized under section 263(a), but are not described above.
2. Book-Tax Conformity
    The IRS and Treasury Department request comments on whether there 
are types of expenditures other than those discussed above for which 
the taxpayer's treatment for financial or regulatory accounting 
purposes should be taken into account in determining the treatment for 
federal income tax purposes or to simplify tax reporting.
3. Amortization Periods
    Certain intangibles have readily ascertainable useful lives that 
can be determined with reasonable accuracy, while others do not. The 
IRS and Treasury Department expect to provide safe harbor recovery 
periods and methods for certain capitalized expenditures that do not 
have readily ascertainable useful lives. Comments are requested 
regarding whether guidance should provide one uniform period or 
multiple recovery periods and what the recovery periods and methods 
should be.
4. De Minimis Rules
    The IRS and Treasury Department request comments on whether there 
are types of expenditures other than those discussed above for which it 
would be appropriate to prescribe de minimis rules that would not 
require capitalization under section 263(a). If there are such 
categories or thresholds, comments are requested on how expenditures 
would be aggregated in applying these de minimis rules.
5. Costs of Software
    The IRS and Treasury Department request comments on what rules and 
principles should be used to distinguish acquired software from 
developed software and the administrability of

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those rules and principles. See Rev. Proc. 2000-50, 2000-2 C.B. 601.

Heather C. Maloy,
Associate Chief Counsel (Income Tax & Accounting).
[FR Doc. 02-1678 Filed 1-23-02; 8:45 am]
BILLING CODE 4830-01-P