[Federal Register Volume 67, Number 244 (Thursday, December 19, 2002)]
[Proposed Rules]
[Pages 77701-77724]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-31859]


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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