[Federal Register Volume 69, Number 2 (Monday, January 5, 2004)]
[Rules and Regulations]
[Pages 436-465]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-31823]



[[Page 435]]

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Part III





Department of the Treasury





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Internal Revenue Service



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26 CFR Parts 1 and 602



Guidance Regarding Deduction and Capitalization of Expenditures; Final 
Rule

  Federal Register / Vol. 69, No. 2 / Monday, January 5, 2004 / Rules 
and Regulations  

[[Page 436]]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9107]
RIN 1545-BA00


Guidance Regarding Deduction and Capitalization of Expenditures

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations that explain how 
section 263(a) of the Internal Revenue Code (Code) applies to amounts 
paid to acquire or create intangibles. This document also contains 
final regulations under section 167 of the Code that provide safe 
harbor amortization for certain intangibles, and final regulations 
under section 446 of the Code that explain the manner in which 
taxpayers may deduct debt issuance costs.

DATES: Effective Date: These regulations are effective December 31, 
2003.
    Applicability Dates: For dates of applicability of the final 
regulations, see Sec. Sec.  1.167(a)-3(b)(4), 1.263(a)-4(o), 1.263(a)-
5(m), and 1.446-5(d).

FOR FURTHER INFORMATION CONTACT: Andrew J. Keyso, (202) 622-4800 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION: 

Paperwork Reduction Act

    The collection of information in this final rule has been reviewed 
and, pending receipt and evaluation of public comments, approved by the 
Office of Management and Budget (OMB) under 44 U.S.C. 3507 and assigned 
control number 1545-1870.
    The collection of information in this regulation is in Sec.  
1.263(a)-5(f). This information is required to verify the proper 
allocation of certain amounts paid in the process of investigating or 
otherwise pursuing certain transactions involving the acquisition of a 
trade or business. The collection of information is voluntary and is 
required to obtain a benefit. The likely recordkeepers are business 
entities.
    Comments on the collection of information should be sent to the 
Office of Management and Budget, Attn: Desk Officer for the Department 
of the Treasury, Office of Information and Regulatory Affairs, 
Washington, DC 20503, with copies to the Internal Revenue Service, 
Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 
20224. Comments on the collection of information should be received by 
March 5, 2004. Comments are specifically requested concerning:

    Whether the collection of information is necessary for the proper 
performance of the functions of the Internal Revenue Service, including 
whether the information will have practical utility;
    The accuracy of the estimated burden associated with the collection 
of information (see below);
How the quality, utility, and clarity of the information to be 
collected may be enhanced;
How the burden of complying with the collection of information may be 
minimized, including through the application of automated collection 
techniques or other forms of information technology; and
Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of service to provide information.

    Estimated total annual recordkeeping burden: 3,000 hours.
    Estimated average annual burden hours per recordkeeper: 1 hour.
    Estimated number of recordkeepers: 3,000.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    On January 24, 2002, the IRS and Treasury Department published an 
advance notice of proposed rulemaking in the Federal Register (REG-
125638-01; 67 FR 3461) announcing an intention to provide guidance on 
the extent to which section 263(a) of the Internal Revenue Code (Code) 
requires taxpayers to capitalize amounts paid to acquire, create, or 
enhance intangible assets. A notice of proposed rulemaking was 
published in the Federal Register (REG-125638-01; 67 FR 77701) on 
December 19, 2002, proposing regulations under section 263(a) (relating 
to the capitalization requirement), section 167 (relating to safe 
harbor amortization) and section 446 (relating to the allocation of 
debt issuance costs). A public hearing was held on April 22, 2003. In 
addition, written comments responding to the notice of proposed 
rulemaking were received. After consideration of all of the public 
comments, the proposed regulations are adopted as revised by this 
Treasury decision. The revisions are discussed below.

Explanation of Provisions

I. Format of the Final Regulations

    The final regulations modify the format of the proposed 
regulations. The final regulations retain in Sec.  1.263(a)-4 the rules 
requiring capitalization of amounts paid to acquire or create 
intangibles and amounts paid to facilitate the acquisition or creation 
of intangibles. However, the rules requiring capitalization of amounts 
paid to facilitate an acquisition of a trade or business, a change in 
the capital structure of a business entity, and certain other 
transactions are contained in a new Sec.  1.263(a)-5. Dividing the 
rules into two sections enabled the IRS and Treasury Department to 
apply some of the simplifying conventions in the proposed regulations 
to certain acquisitions of tangible assets in Sec.  1.263(a)-5, while 
limiting the application of Sec.  1.263(a)-4 to costs of acquiring and 
creating intangibles. The format of the final regulations contained in 
Sec. Sec.  1.446-5 and 1.167(a)-3 is essentially unchanged from the 
format of the proposed version of these regulations.

II. Explanation and Summary of Comments Concerning Sec.  1.263(a)-4

A. General Principle of Capitalization
    The final regulations identify categories of intangibles for which 
capitalization is required. As in the proposed regulations, the final 
regulations provide that an amount paid to acquire or create an 
intangible not otherwise required to be capitalized by the regulations 
is not required to be capitalized on the ground that it produces 
significant future benefits for the taxpayer, unless the IRS publishes 
guidance requiring capitalization of the expenditure. If the IRS 
publishes guidance requiring capitalization of an expenditure that 
produces future benefits for the taxpayer, such guidance will apply 
prospectively. While most commentators support this approach, some 
commentators expressed concerns that this approach, particularly the 
prospective nature of future guidance, will permit taxpayers to deduct 
expenditures that should properly be capitalized. The IRS and Treasury 
Department continue to believe that the capitalization principles in 
the regulations strike an appropriate balance between the 
capitalization

[[Page 437]]

provisions of the Code and the ability of taxpayers and IRS personnel 
to administer the law, and are a reasonable means of enforcing the 
requirements of section 263(a).
    The final regulations change the general principle of 
capitalization in three respects from the proposed regulations. First, 
Sec.  1.263(a)-4 of the final regulations does not include the rule 
requiring capitalization of amounts paid to facilitate a 
``restructuring or reorganization of a business entity or a transaction 
involving the acquisition of capital, including a stock issuance, 
borrowing, or recapitalization.'' As noted above, the rules requiring 
taxpayers to capitalize amounts paid to facilitate these types of 
transactions are now contained in Sec.  1.263(a)-5.
    Second, the final regulations eliminate the word ``enhance'' from 
portions of the general principle. Commentators expressed concerns that 
the use of the term ``enhance'' would require capitalization in 
unintended circumstances. For example, if a taxpayer acquires goodwill 
as part of the acquisition of a trade or business, future expenditures 
to maintain the reputation of the trade or business arguably could 
constitute amounts paid to ``enhance'' the acquired goodwill. The final 
regulations remove the word ``enhance'' in favor of more specifically 
identifying the types of enhancement for which capitalization is 
appropriate. For example, the final regulations modify the proposed 
regulations to provide that a taxpayer must capitalize an amount paid 
to ``upgrade'' its rights under a membership or a right granted by a 
government agency.
    Third, the final regulations eliminate the use of, and the 
definition of, the term ``intangible asset'' that was contained in the 
proposed regulations. This change was made in an effort to aid 
readability. The final regulations simply identify categories of 
``intangibles'' for which amounts are required to be capitalized.
    The final regulations clarify that nothing in Sec.  1.263(a)-4 
changes the treatment of an amount that is specifically provided for 
under any other provision of the Code (other than section 162(a) or 
212) or regulations thereunder. Thus, where another section of the Code 
(or regulations under that section) prescribes a specific treatment of 
an amount, the provisions of that section apply and not the rules 
contained in these final regulations. For example, where the treatment 
of an insurance company's policy acquisition expenses is prescribed by 
sections 848 and 197(f)(5) of the Code, those sections apply and not 
these final regulations. Similarly, capitalization is not required 
under the final regulations for expenditures that are deductible under 
section 174.
    The general definition of a separate and distinct intangible asset 
in paragraph (b)(3) of the final regulations is unchanged from the 
proposed regulations, except to clarify that a separate and distinct 
intangible asset must be intrinsically capable of being sold, 
transferred, or pledged (ignoring any restrictions imposed on 
assignability) separate and apart from a trade or business. The final 
regulations also clarify that a fund is treated as a separate and 
distinct intangible asset of the taxpayer if amounts in the fund may 
revert to the taxpayer.
    In addition, the application of the separate and distinct 
intangible asset definition to specific intangibles has been further 
limited in the final regulations. The final regulations provide that an 
amount paid to create a package design, computer software or an income 
stream from the performance of services under a contract is not treated 
as an amount that creates a separate and distinct intangible asset. For 
a further discussion of issues pertaining to computer software, see the 
discussion in Part II.H. of this Preamble titled ``Computer software 
issues.'' In addition, examples are added to paragraph (l) of the final 
regulations to clarify that product launch costs and stocklifting costs 
do not create a separate and distinct intangible asset.
B. Clear Reflection of Income
    Commentators questioned how the regulations interact with the clear 
reflection of income requirement of section 446(b) and whether the IRS 
would argue that an expenditure that is not required to be capitalized 
by the regulations should nonetheless be capitalized on the ground that 
deduction of the expenditure does not clearly reflect income under 
section 446. If an amount paid to acquire or create an intangible is 
not required to be capitalized by another provision of the Code or 
regulations thereunder or by the final regulations or in subsequent 
published guidance, the IRS will not argue that the clear reflection of 
income requirement of section 446(b) and the regulations thereunder 
necessitates capitalization.
C. Intangibles Acquired From Another
    The final regulations retain the requirement of the proposed 
regulations that a taxpayer must capitalize amounts paid to another 
party to acquire any intangible from that party in a purchase or 
similar transaction. Like the proposed regulations, the final 
regulations provide a nonexclusive list of intangibles for which 
capitalization is required. To further clarify that the list is 
illustrative, the final regulations modify the introductory language to 
specifically state that the list contains ``examples'' of intangibles 
within the scope of paragraph (c).
D. Created Intangibles
1. In General
    The final regulations retain the eight categories of created 
intangibles contained in the proposed regulations. As discussed above, 
the final regulations eliminate the term ``enhance'' from the general 
principle. Instead, as described below, several of the categories of 
created intangibles are revised to more specifically identify the types 
of enhancements for which capitalization is required.
    A commentator noted that the approach adopted in the regulations of 
defining categories of intangibles may be subject to abuse if taxpayers 
seek to deduct expenditures based on immaterial distinctions between 
those expenditures and expenditures included in the listed categories. 
To address this concern, the final regulations contain a rule providing 
that the determination of whether an amount is paid to create an 
intangible identified in the final regulations is made based on all of 
the facts and circumstances, disregarding distinctions between the 
labels used in the regulations to describe the intangible and the 
labels used by the taxpayer and other parties to describe the 
transaction. The IRS and Treasury Department intend to construe broadly 
the categories of intangibles identified in the regulations in response 
to any narrow technical arguments that an intangible created by the 
taxpayer is not literally described in the categories. For example, a 
taxpayer that obtains what is, in substance, a membership in an 
organization cannot avoid capitalization under paragraph (d)(4) of the 
final regulations by arguing that the right is titled an ``admission'' 
or that the right explicitly provides the taxpayer a ``participation 
right'' but not a membership.
2. Financial Interests
    The final regulations require taxpayers to capitalize an amount 
paid to another party to create, originate, enter into, renew or 
renegotiate with that party certain financial interests. The final 
regulations retain the categories of financial interests contained in 
the proposed regulations, with minor modifications.

[[Page 438]]

    The final regulations eliminate the rule contained in paragraph 
(d)(2)(ii) of the proposed regulations providing that capitalization is 
not required for an amount paid to create or originate an option or 
forward contract 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. This rule was unnecessary and was 
incorrectly read by some commentators to suggest that taxpayers could 
immediately deduct amounts paid to create or originate an option or 
forward contract. The final regulations clarify the treatment of these 
amounts.
3. Prepaid Expenses
    The final regulations retain the rule contained in the proposed 
regulations. The reference to ``benefits to be received in the future'' 
has been deleted to avoid any implication of a ``significant future 
benefits'' test. No comments were received suggesting changes to the 
rule.
4. Certain Memberships and Privileges
    The final regulations retain the rule contained in the proposed 
regulations, but clarify that capitalization also is required if a 
taxpayer renegotiates or upgrades a membership or privilege. The final 
regulations also modify an example contained in the proposed 
regulations that does not address the implications of section 274(a)(3) 
and unintentionally implies that an amount paid to obtain membership in 
a social club is required to be capitalized under the regulations. The 
revised example addresses an amount paid to obtain a membership in a 
trade association.
5. Certain Rights Obtained From a Governmental Agency
    The final regulations retain the rule contained in the proposed 
regulations, but clarify that capitalization also is required if a 
taxpayer renegotiates or upgrades its rights. For example, a holder of 
a business license that pays an amount to upgrade its license, enabling 
it to sell additional types of products or services, must capitalize 
that amount.
    Several commentators questioned whether an amount paid to a 
government agency to obtain a patent from that agency is required to be 
capitalized under this rule if section 174 applies to the amount. As 
previously discussed, the regulations do not affect the treatment of an 
expenditure 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 the final regulations if the amount is 
deductible under section 174.
6. Certain Contract Rights
    The final regulations retain the rules contained in the proposed 
regulations regarding capitalization of amounts paid to enter into 
certain agreements. In addition, the final regulations clarify that 
taxpayers must capitalize amounts paid to another party to create, 
originate, enter into, renew, or renegotiate with that party an 
agreement not to acquire additional ownership interests in the taxpayer 
(i.e., a standstill agreement). The IRS and Treasury Department believe 
that the benefits obtained by the taxpayer from a standstill agreement 
are similar to the benefits that result from other agreements 
identified in the rule and that capitalization is therefore 
appropriate. The rule does not apply to a standstill agreement governed 
by another provision of the Code, such as section 162(k). An example 
has been added to the final regulations to illustrate the application 
of this rule. The final regulations also clarify that a taxpayer must 
capitalize costs that facilitate the creation of an annuity, endowment 
contract or insurance contract that does not have or provide for cash 
value (e.g., a comprehensive liability policy or a property and 
casualty policy) if the taxpayer is the covered party under the 
contract.
    The final regulations add three rules to address public comments 
that capitalization is not appropriate if the taxpayer has only a hope 
or expectation that a customer or supplier will begin or continue a 
business relationship with the taxpayer. First, the final regulations 
provide that amounts paid with the mere hope or expectation of 
developing or maintaining a business relationship are not required to 
be capitalized, provided the amount is not contingent on the 
origination, renewal or renegotiation of an agreement. The IRS and 
Treasury Department believe that amounts that are contingent on the 
origination, renewal or renegotiation of an agreement are properly 
capitalized as amounts paid to originate, renew or renegotiate the 
agreement. Second, the final regulations provide that an agreement does 
not provide a ``right'' to provide services if the agreement merely 
provides that the taxpayer will stand ready to provide services if 
requested, but places no obligation on another party to request or pay 
for the taxpayer's services. Third, the final regulations provide that 
an agreement that may be terminated at will by the other party (or 
parties) to the agreement prior to the expiration of the period 
prescribed by the ``12-month rule'' does not constitute an agreement 
providing the taxpayer the right to use property or provide (or 
receive) services. However, where the other party (or parties) to the 
agreement is economically compelled not to terminate the agreement 
prior to the expiration of the period prescribed by the ``12-month 
rule'' in the regulations, then the agreement is not considered to be 
an agreement that may be terminated at will. Several examples are added 
to the final regulations to illustrate the application of these rules.
    The final regulations also clarify the meaning of ``renegotiate.'' 
Under the final regulations, a taxpayer is treated as renegotiating an 
agreement if the terms of the agreement are modified. In addition, a 
taxpayer is treated as renegotiating an agreement if the taxpayer 
enters into a new agreement with the same party (or substantially the 
same parties) to a terminated agreement, the taxpayer could not cancel 
the terminated agreement without the agreement of the other party (or 
parties), and the other party (or parties) would not have agreed to the 
cancellation unless the taxpayer entered into the new agreement. See 
U.S. Bancorp v. Commissioner, 111 T.C. 231 (1998).
    The final regulations retain the $5,000 de minimis rule contained 
in the proposed regulations. In addition, the final regulations provide 
that, if an amount is paid in the form of property, the property is 
valued at its fair market value at the time of the payment for purposes 
of determining whether the de minimis rule applies. The final 
regulations also retain the pooling method for de minimis costs of 
creating similar agreements. See Part II.G. of this Preamble titled 
``Safe harbor pooling methods'' for a further explanation of rules 
pertaining to pooling.
7. Certain Contract Terminations
    The final regulations retain the rule contained in the proposed 
regulations. No comments were received suggesting changes to the rule. 
The final regulations, however, clarify that the contract termination 
provisions do not apply to amounts paid to terminate a transaction 
subject to Sec.  1.263(a)-5. See Part III of this Preamble 
(``Explanation and Summary of Comments Concerning Sec.  1.263(a)-5'') 
for a discussion of the treatment of amounts paid to terminate a 
transaction described in Sec.  1.263(a)-5.
8. Benefits Arising From the Provision, Production, or Improvement of 
Real Property
    The final regulations retain the rule contained in the proposed 
regulations, but clarify that the exceptions to the

[[Page 439]]

rule apply only to the extent the taxpayer receives fair market value 
consideration for the real property.
9. Defense or Perfection of Title to Intangible Property
    The final regulations retain the rule contained in the proposed 
regulations. No comments were received suggesting changes to the rule. 
The final regulations clarify that amounts paid to another party to 
terminate an agreement permitting that party to purchase the taxpayer's 
intangible property or to terminate a transaction described in Sec.  
1.263(a)-5 are not treated as amounts paid to defend or perfect title. 
See Part III of this Preamble (``Explanation and Summary of Comments 
Concerning Sec.  1.263(a)-5'') for a discussion of the treatment of 
amounts paid to terminate a transaction described in Sec.  1.263(a)-5.
E. Transaction Costs
1. In General
    The final regulations require taxpayers to capitalize amounts that 
facilitate the acquisition or creation of an intangible. The proposed 
regulations provide that an amount facilitates a transaction if it is 
paid ``in the process of pursuing the transaction.'' Some commentators 
questioned whether amounts paid to investigate a transaction constitute 
amounts paid in the process of pursuing the transaction. The IRS and 
Treasury Department believe that it is inappropriate to distinguish 
amounts paid to investigate the acquisition or creation of an 
intangible from other amounts paid in the process of acquiring or 
creating an intangible. To clarify that investigatory costs are within 
the scope of the rule, the final regulations provide that amounts 
facilitate a transaction if they are paid in the process of 
``investigating or otherwise pursuing the transaction.'' In addition, 
the final regulations clarify that an amount paid to determine the 
value or price of an intangible is an amount paid in the process of 
investigating or otherwise pursuing the transaction.
    The proposed regulations provide that, in determining whether an 
amount is paid to facilitate a transaction, the fact that the amount 
would (or would not) have been paid ``but for'' the transaction is 
``not relevant.'' The IRS and Treasury Department believe that the fact 
that the amount would or would not have been paid ``but for'' the 
transaction is a relevant factor, but not the only factor, to be 
considered. Accordingly, the final regulations revise this rule to 
provide that the fact that the amount would (or would not) have been 
paid ``but for'' the transaction is a relevant but not a 
``determinative'' factor.
    The final regulations eliminate the rule in the proposed 
regulations that treats amounts paid to terminate (or facilitate the 
termination of) an existing agreement as facilitating another 
transaction that is expressly conditioned on the termination of the 
agreement. The IRS and Treasury Department decided that well advised 
taxpayers could easily avoid the rule by using general representations, 
while uninformed taxpayers inadvertently could be caught by the rule. 
The IRS and the Treasury Department considered replacing the 
``expressly conditioned'' rule with a ``mutually exclusive'' rule 
similar to the one contained in Sec.  1.263(a)-5 (see Part III of this 
Preamble). A mutually exclusive rule was not adopted in Sec.  1.263(a)-
4 because such a rule could have been interpreted as requiring 
capitalization of contract termination costs that historically have 
been deductible (for example, an amount paid to terminate a burdensome 
supply contract if the taxpayer enters into a new supply contract (for 
which capitalization is required under the regulations) with another 
party if the taxpayer could not contract with both parties). A mutually 
exclusive rule also was not adopted in the final regulations because it 
would have been administratively difficult to apply such a rule in the 
context of ordinary business transactions. Instead, Sec.  1.263(a)-4 of 
the final regulations provides that an amount paid to terminate (or 
facilitate the termination of) an existing agreement does not 
facilitate the acquisition or creation of another agreement.
    Commentators expressed concern that the rules in the proposed 
regulations requiring taxpayers to capitalize amounts paid in the 
process of pursuing certain agreements could be interpreted very 
broadly to require taxpayers to capitalize amounts that should be 
treated as deductible costs of sustaining or expanding the taxpayer's 
business. To address this concern, the final regulations add a rule 
providing that an amount is treated as not paid in the process of 
investigating or otherwise pursuing the creation of a contract right if 
the amount relates to activities performed before the earlier of the 
date the taxpayer begins preparing its bid for the contract or the date 
the taxpayer begins discussing or negotiating the contract with another 
party to the contract. An example is provided in the final regulations 
illustrating the application of the rule.
2. Simplifying Conventions
    The final regulations retain the simplifying conventions applicable 
to employee compensation, overhead, and de minimis costs, with several 
modifications.
    For example, the final regulations treat as employee compensation 
certain amounts paid to persons who may not be employees of the 
taxpayer under section 3401(c). Specifically, the final regulations 
provide that a guaranteed payment to a partner in a partnership is 
treated as employee compensation. In addition, annual compensation paid 
to a director of a corporation is treated as employee compensation. The 
final regulations also provide that, in the case of an affiliated group 
of corporations filing a consolidated federal income tax return, a 
payment by one member of the group to a second member of the group for 
services performed by an employee of the second member is treated as 
employee compensation if the services are performed at a time during 
which both members are affiliated. Other than this rule for entities 
joining in a consolidated return, the final regulations do not treat 
employees of one entity as employees of a related entity. The limited 
exception is made for entities joining in a consolidated return because 
these entities are appropriately viewed as a single taxpayer for 
purposes of the employee compensation simplifying convention. The IRS 
and Treasury Department believe that when other related entities 
provide services to each other, they generally will maintain records of 
the time charged and will not be subject to undue recordkeeping burdens 
as a result of section 263(a).
    Several commentators suggested that the simplifying convention for 
employee compensation should apply to amounts paid to independent 
contractors who are not hired specifically to facilitate a capital 
transaction. For example, many companies hire outside contractors to 
provide administrative and secretarial services, and these contractors 
work on a variety of transactions, only some of which may be capital. 
The final regulations extend the employee compensation simplifying 
convention to amounts paid to outside contractors for secretarial, 
clerical, and similar administrative services.
    The final regulations retain the $5,000 de minimis threshold 
contained in the proposed regulations. Some commentators suggested that 
the threshold be a higher amount, or at least be indexed for inflation. 
The final regulations do not adopt these

[[Page 440]]

suggestions, but provide that the IRS may prescribe a higher threshold 
amount in future published guidance. The final regulations also provide 
that, for purposes of determining whether a transaction cost paid in 
the form of property is de minimis, the property is valued at its fair 
market value at the time of the payment. The final regulations also 
retain the pooling method for de minimis transaction costs. See Part 
II.G. of this Preamble titled ``Safe harbor pooling methods'' for a 
further explanation of the rules relating to pooling.
    The final regulations permit taxpayers to elect to capitalize 
employee compensation, overhead, or de minimis costs. Several 
commentators noted that taxpayers may capitalize such costs for 
financial accounting purposes, and it may be difficult to segregate 
these costs for Federal income tax purposes. The final regulations 
permit taxpayers to make this capitalization election with regard to 
any or all of the three categories of costs covered by the simplifying 
conventions (i.e., employee compensation, overhead, or de minimis 
costs).
F. 12-Month Rule
    The regulations retain the 12-month rule contained in the proposed 
regulations. Under the 12-month rule, a taxpayer is not required to 
capitalize amounts paid to create (or facilitate the creation of) 
certain rights or benefits with a brief duration. Some commentators 
suggested that the first prong of the measuring period should be 
deleted, resulting in a rule that considers only whether the benefit 
extends beyond the end of the taxable year following the year in which 
the payment is made. The final regulations do not adopt this 
suggestion. The IRS and Treasury continue to believe that the rule 
contained in the proposed regulations is sufficient to ease the 
recordkeeping burden for transactions of relatively brief duration.
    The final regulations clarify that if a taxpayer is permitted to 
terminate an agreement described in this rule after a notice period, in 
determining whether the ``12 month rule'' applies, amounts paid to 
terminate the agreement before the end of the notice period create a 
benefit for the taxpayer that lasts for the amount of time by which the 
notice period is shortened.
    The final regulations permit taxpayers to elect not to apply the 
12-month rule to categories of similar transactions. The IRS and 
Treasury Department recognize that some taxpayers may capitalize 
amounts for financial accounting purposes that would not be required to 
be capitalized for Federal income tax purposes due to the 12-month 
rule. In some cases, it may be difficult for taxpayers to identify and 
calculate these amounts for purposes of applying the 12-month rule. For 
this reason, the final regulations permit taxpayers to elect to 
capitalize these amounts notwithstanding that the 12-month rule would 
not require capitalization.
G. Safe Harbor Pooling Methods
    The final regulations adopt, with slight modifications, the pooling 
methods contained in the proposed regulations for de minimis costs and 
the 12-month rule. The pooling rules in the final regulations are very 
general. However, the IRS may publish guidance in the Internal Revenue 
Bulletin prescribing additional rules for applying the pooling methods 
to particular industries or to specific types of transactions.
    The final regulations provide that a taxpayer may utilize the 
pooling methods only if the taxpayer reasonably expects to engage in at 
least 25 similar transactions during the taxable year. The final 
regulations require a minimum number of similar transactions to prevent 
inappropriate skewing of the average cost or average benefit period. 
Although pooling reduces the burden on taxpayers of having to 
separately analyze each transaction, this burden is not as significant 
when there are only a small number of transactions to consider.
    The final regulations do not require the same pools to be used 
under the pooling method as are required for depreciation purposes 
under section 167. However, taxpayers should draw no inferences that a 
pool permitted under the regulations constitutes an acceptable pool for 
depreciation purposes under section 167.
    A commentator suggested that the final regulations permit taxpayers 
to estimate the costs (or renewal expectancy) of items included in a 
pool based on a sample of items included in the pool. The final 
regulations do not adopt this suggestion. The IRS and Treasury 
Department believe that it is inappropriate to apply the pooling rules 
by looking at a sample of items included in the pool. In estimating the 
renewal expectancy of items in a pool, however, taxpayers are permitted 
to consider their historic experience with similar items.
    The final regulations clarify that a pooling method authorized by 
the regulations constitutes a method of accounting. Accordingly, a 
taxpayer that adopts (or changes to) a pooling method authorized by the 
regulations must use the method for the year of adoption (or year of 
change) and for all subsequent taxable years during which the taxpayer 
qualifies to use the method, unless a change to another method is 
required by the Commissioner, or unless permission to change to another 
method is granted by the Commissioner.
    The final regulations also add a rule that is intended to prevent 
abuse of the de minimis rules through pooling of similar agreements. 
The IRS and Treasury Department are concerned that one or more large-
dollar transactions may qualify under the de minimis rule if averaged 
with numerous small-dollar transactions. To discourage this potential 
abuse, the regulations prohibit the inclusion of an agreement in the 
pool if the amount paid to obtain the agreement is reasonably expected 
to differ significantly from the average amount attributable to other 
agreements properly included in the pool. The final regulations add an 
example illustrating the application of this rule.
H. Computer Software Issues
    Based on public comments, the IRS and Treasury Department decided 
that issues relating to the development and implementation of computer 
software are more appropriately addressed in separate guidance, and not 
in these final regulations. While these final regulations require a 
taxpayer to capitalize an amount paid to another party to acquire 
computer software from that party in a purchase or similar transaction 
(see Sec.  1.263(a)-4(c)), nothing in these regulations is intended to 
affect the determination of whether computer software is acquired from 
another party in a purchase or similar transaction, or whether computer 
software is developed or otherwise self-created (including amounts paid 
to implement Enterprise Resource Planning (ERP) software). While the 
proposed regulations identify ERP implementation costs as an issue to 
be addressed in the final regulations, the IRS and Treasury Department 
believe that rules regarding the treatment of such costs are more 
appropriately addressed in separate guidance dedicated exclusively to 
computer software issues. Until separate guidance is issued, taxpayers 
may continue to rely on Revenue Procedure 2000-50 (2000-2 C.B. 601).

III. Explanation and Summary of Comments Concerning Sec.  1.263(a)-5

A. In General
    Section 1.263(a)-5 contains rules requiring taxpayers to capitalize 
amounts paid to facilitate the acquisition of a trade or business, a

[[Page 441]]

change in the capital structure of a business entity, and certain other 
transactions. The types of transactions covered by Sec.  1.263(a)-5 are 
more clearly identified than in paragraph (b)(1)(iii) of the proposed 
regulations. Section 1.263(a)-5 applies to acquisitions of an ownership 
interest in an entity conducting a trade or business only if, 
immediately after the acquisition, the taxpayer and the entity are 
related within the meaning of section 267(b) or 707(b). Other 
acquisitions of an ownership interest in an entity are governed by the 
rules contained in Sec.  1.263(a)-4, and not the rules contained in 
Sec.  1.263(a)-5.
    Similar to the Sec.  1.263(a)-4 final regulations, the Sec.  
1.263(a)-5 regulations clarify that an amount facilitates a transaction 
if it is paid in the process of ``investigating or otherwise pursuing 
the transaction'' and that an amount paid to determine the value or 
price of a transaction is an amount paid in the process of 
investigating or otherwise pursuing that transaction. In addition, the 
fact that an amount would (or would not) have been paid ``but for'' the 
transaction is a relevant, but not determinative, factor in evaluating 
whether an amount is paid to facilitate a transaction.
B. Acquisition of Assets Constituting a Trade or Business
    As explained in the preamble to the proposed regulations, the 
proposed regulations (and the simplifying conventions in the proposed 
regulations) apply only to amounts paid to acquire (or facilitate the 
acquisition of) intangibles acquired as part of a trade or business and 
do not apply to amounts paid to acquire (or facilitate the acquisition 
of) tangible assets acquired as part of a trade or business. The 
preamble to the proposed regulations further notes that the IRS and 
Treasury Department were considering the application of the rules in 
the proposed regulations to tangible assets acquired as part of a trade 
or business in order to provide a single administrable standard in 
these transactions. To avoid the application of one set of rules to 
intangible assets acquired in the acquisition of a trade or business 
and a different set of rules to the tangible assets acquired in the 
acquisition, the final regulations under Sec.  1.263(a)-5 provide a 
single set of rules for amounts paid to facilitate an acquisition of a 
trade or business, regardless of whether the transaction is structured 
as an acquisition of the entity or as an acquisition of assets 
(including tangible assets) constituting a trade or business.
C. Special Rules for Certain Costs
1. Borrowing Costs
    The final regulations retain the rule in the proposed regulations 
that an amount paid to facilitate a borrowing does not facilitate 
another transaction (other than the borrowing).
2. Costs of Asset Sales
    The final regulations provide that an amount paid to facilitate a 
sale of assets does not facilitate a transaction other than the sale, 
regardless of the circumstances surrounding the sale. This modifies the 
rule in the proposed regulations, which requires capitalization of 
amounts paid to facilitate a sale of assets where the sale is required 
by law, regulatory mandate, or court order and the sale itself 
facilitates another capital transaction. Several commentators argued 
that costs to dispose of assets are properly viewed as costs to 
facilitate the sale, and not costs to facilitate a subsequent 
transaction. The IRS and Treasury Department have adopted this 
suggestion and revised the rule in the final regulations.
3. Mandatory Stock Distributions
    The final regulations modify the rules in the proposed regulations 
relating to government mandated divestitures of stock. The proposed 
regulations provide that capitalization is not required for a 
distribution of stock by a taxpayer to its shareholders if the 
divestiture is required by law, regulatory mandate, or court order, 
except in cases where the divestiture itself facilitates another 
capital transaction. The final regulations eliminate the exception. In 
addition, the final regulations clarify that costs to organize an 
entity to receive the divested properties or to facilitate the transfer 
of certain divested properties to a distributed entity also are not 
required to be capitalized under section 263(a). See sections 248 and 
709. An example has been added to the final regulations illustrating 
this rule.
4. Bankruptcy Reorganization Costs
    Commentators suggested that the final regulations clarify that not 
all costs incurred in the process of pursuing a bankruptcy 
reorganization under Chapter 11 of the Bankruptcy Code must be 
capitalized. The final regulations contain a special rule defining the 
scope of bankruptcy costs required to be capitalized. Under the rule, 
costs of the debtor to institute or administer a Chapter 11 proceeding 
generally are required to be capitalized. However, costs to operate the 
debtor's business during a Chapter 11 proceeding (including the types 
of costs described in Revenue Ruling 77-204 (1977-1 C.B. 40)) do not 
facilitate the bankruptcy and are treated in the same manner as such 
costs would have been treated had the bankruptcy proceeding not been 
instituted. In addition, the final regulations provide that 
capitalization is not required for amounts paid by a taxpayer to defend 
against the commencement of an involuntary bankruptcy proceeding 
against the taxpayer.
    Commentators specifically requested that the final regulations 
address the treatment of costs incurred in a Chapter 11 bankruptcy 
proceeding that is instituted in order to manage and resolve tort 
claims and distinguish these proceedings from other bankruptcy cases. 
The final regulations do not distinguish between a bankruptcy 
proceeding that is instituted to resolve tort claims and other 
bankruptcy proceedings. However, the final regulations clarify that a 
specific amount paid to formulate, analyze, contest or obtain approval 
of the portion of a plan of reorganization under Chapter 11 that 
resolves the taxpayer's tort liability is not required to be 
capitalized if the amount would have been treated as an ordinary and 
necessary business expense under section 162 had the bankruptcy 
proceeding not been instituted
5. Stock Issuance Costs of Open-End Regulated Investment Companies
    The final regulations retain the rule that amounts paid by an open-
end regulated investment company to facilitate an issuance of its stock 
are treated as amounts that do not facilitate a capital transaction 
unless the amounts are paid during the initial stock offering period.
6. Integration Costs
    The final regulations retain the rule in the proposed regulations 
that an amount paid to integrate the business operations of the 
taxpayer with the business operations of another entity does not 
facilitate a transaction described in Sec.  1.263(a)-5, regardless of 
when the integration activities occur.
7. Costs Associated With Terminated Transactions
    The final regulations clarify when costs of terminating a 
transaction described in Sec.  1.263(a)-5 (including break-up fees) are 
treated as facilitating another transaction described in Sec.  
1.263(a)-5. Under the proposed regulations, termination costs 
facilitate a subsequent transaction if the subsequent transaction is 
``expressly conditioned''

[[Page 442]]

on the termination. The final regulations do not contain an ``expressly 
conditioned'' rule. Instead, an amount paid to terminate (or facilitate 
the termination of) an agreement to enter into a transaction described 
in the regulations is treated as facilitating another transaction 
described in the regulations only if the transactions are mutually 
exclusive and the agreement is terminated to enable the taxpayer to 
engage in the second transaction. In addition, an amount paid to 
facilitate a transaction described in the regulations is treated as 
facilitating a second transaction described in the regulations only if 
the transactions are mutually exclusive and the first transaction is 
abandoned to enable the taxpayer to engage in the second transaction. 
The final regulations contain several examples to demonstrate the 
application of these rules.
D. Simplifying Conventions
    In general, the simplifying conventions applicable to transactions 
described in Sec.  1.263(a)-5 are similar to the simplifying 
conventions applicable to acquisitions or creations of intangibles 
governed by Sec.  1.263(a)-4. See Part II.E.2 of this Preamble titled 
``Simplifying Conventions'' for an explanation of the simplifying 
conventions applicable to the acquisition or creation of an intangible 
governed by Sec.  1.263(a)-4.
    The simplifying convention for employee compensation treats amounts 
paid to persons who are not employees as employee compensation if the 
amounts are paid for secretarial, clerical, or similar administrative 
support services. In the context of transactions described in Sec.  
1.263(a)-5, this rule does not apply to services involving the 
preparation and distribution of proxy solicitations and other documents 
seeking shareholder approval of a transaction described in Sec.  
1.263(a)-5. The IRS and Treasury Department believe that these 
inherently facilitative services, which are commonly performed by 
independent contractors, are appropriately capitalized.
    In addition, the final regulations provide that the term ``de 
minimis costs'' does not include commissions paid to facilitate a 
transaction described in Sec.  1.263(a)-5. This rule maintains 
consistency with the rule in Sec.  1.263(a)-4(e)(4)(iii)(B), which 
provides that the de minimis rule does not apply to commissions paid to 
facilitate the acquisition or creation of certain financial interests.
E. Special Rules for Certain Acquisitive Transactions
    The final regulations contain a ``bright line date'' rule and an 
``inherently facilitative'' rule intended to aid the determination of 
amounts paid to facilitate certain acquisitive transactions. The final 
regulations modify the bright line date rule provided in the proposed 
regulations. Under the final regulations, an amount (that is not an 
inherently facilitative amount) facilitates the transaction only if the 
amount relates to activities performed on or after the earlier of (i) 
the date on which a letter of intent, exclusivity agreement, or similar 
written communication is executed by representatives of the acquirer 
and the target or (ii) the date on which the material terms of the 
transaction are authorized or approved by the taxpayer's board of 
directors (or other appropriate governing officials). Where board 
approval is not required for a particular transaction, the bright line 
date for the second prong of the test is the date on which the acquirer 
and the target execute a binding written contract reflecting the terms 
of the transaction.
    Many comments were received concerning the bright line dates. Some 
commentators noted that any bright line date is inappropriate and that 
the determination should be based on all of the facts and circumstances 
surrounding the transaction. As discussed in the preamble to the 
proposed regulations, the IRS and Treasury Department continue to 
believe that a bright line rule is necessary to eliminate the 
subjectivity and controversy inherent in this area. Further, the IRS 
and Treasury Department believe that the bright line rule is within the 
scope of the authority of the IRS and Treasury Department to prescribe 
rules necessary to enforce the requirements of section 263(a), and that 
the bright line rule, as modified in these final regulations, serves as 
an appropriate and objective standard for determining the point in time 
at which amounts paid in certain acquisitive transactions must be 
capitalized.
    Some commentators who agreed with the use of a bright line date 
rule to improve administrability of section 263(a) suggested that the 
bright line date should be the date the taxpayer's board of directors 
approves a transaction. The date of the board of directors approval 
may, in some cases, be the date determined under the rule contained in 
the final regulations. However, the IRS and Treasury Department believe 
that an earlier date is more appropriate where the parties have 
mutually agreed to pursue a transaction, notwithstanding the fact that 
the parties are not bound to complete the transaction. Accordingly, the 
rule requires capitalization if the parties execute a letter of intent, 
exclusivity agreement, or similar written communication. The term 
similar written communication in the rule is not intended to include a 
confidentiality agreement.
    The board of directors approval date contemplated by the rule is 
not the date the board authorizes a committee (or management) to 
explore the possibility of a transaction with another party. 
Additionally, the board of directors approval date contemplated by the 
rule is not intended to be the date the board ratifies a shareholder 
vote in favor of the transaction.
    Some commentators suggested that the final regulations clarify how 
the bright line date rule applies to a target that puts itself up for 
auction. These commentators noted that, under the proposed regulations, 
submission of a bid by a bidder could trigger the bright line date for 
the target, even if the target has not made any decision regarding the 
bid. Under the final regulations, submission of a bid by a bidder does 
not trigger the bright line date for the target because the first part 
of the test requires execution by both the acquirer and the target and 
the second part of the test is applied independently by the acquirer 
and the target. The final regulations include an example illustrating 
the application of the rule in this case.
    The final regulations specifically identify the types of 
transactions to which the bright line date and inherently facilitative 
rules apply. Some commentators suggested that the final regulations 
extend the rule to apply not only to acquisitive transactions, but to 
spin-offs, stock offerings, and acquisitions of individual assets that 
do not constitute a trade or business. The IRS and Treasury Department 
believe that the bright line test is not suitable for these 
transactions and that amounts paid in the process of investigating or 
otherwise pursuing these transactions are appropriately capitalized.
    Regarding the inherently facilitative rule contained in the 
proposed regulations, several commentators suggested that the rule be 
deleted or changed to a rebuttable presumption that the identified 
amounts are capital. The final regulations do not adopt this 
suggestion. The IRS and Treasury Department believe that the list of 
inherently facilitative amounts properly identifies certain types of 
costs that are capital regardless of when they are incurred. In 
addition, a rebuttable presumption would not provide the certainty 
sought by the regulations.

[[Page 443]]

However, the final regulations modify the list of inherently 
facilitative amounts to more clearly identify the types of costs 
considered inherently facilitative. For example, the proposed 
regulations treat ``amounts paid for activities performed in 
determining the value of the target'' as inherently facilitative costs. 
Commentators expressed concerns that this language would require 
taxpayers to capitalize all due diligence costs. The final regulations 
tighten this category to include amounts paid for ``securing an 
appraisal, formal written evaluation, or fairness opinion related to 
the transaction.'' General due diligence costs are intended to be 
addressed by the bright line test, not the inherently facilitative 
rules.
    Some commentators questioned whether the regulations are intended 
to affect the treatment of an expenditure under section 195. As a 
result of section 195(c)(1)(B), the regulations are relevant in 
determining whether an expenditure constitutes a start-up expenditure 
within the meaning of section 195. An amount cannot constitute a start-
up expenditure within the meaning of section 195(c)(1)(B) if the amount 
is a capital expenditure under section 263(a). Accordingly, amounts 
required to be capitalized under the final regulations do not 
constitute start-up expenditures within the meaning of section 
195(c)(1). Conversely, amounts that are not required to be capitalized 
under the final regulations may constitute start-up expenditures within 
the meaning of section 195(c)(1) provided the other requirements of 
that section are met.
F. Hostile Takeover Defense Costs
    The IRS and Treasury Department decided that the rules in the 
proposed regulations for amounts paid to defend against a hostile 
takeover attempt are unnecessary. The hostile transaction rule in the 
proposed regulations does not permit taxpayers to deduct costs that 
otherwise would have been capitalized under the regulations. For 
example, the hostile transaction rule does not apply to any inherently 
facilitative costs or to costs that facilitate another capital 
transaction (for example, a recapitalization or a proposed merger with 
a white knight). Other amounts that a target would pay in defending 
against a hostile acquisition would not be capitalized under the final 
regulations either because the costs would not be paid in investigating 
or otherwise pursuing the transaction with the hostile acquirer (for 
example, costs to seek an injunction against the acquisition) or would 
relate to activities performed before the bright line dates (while the 
transaction is hostile, the target will not execute any agreements with 
the acquirer and the target's board of directors will not authorize the 
acquisition). Thus, the IRS and Treasury Department believe the hostile 
transaction rule in the proposed regulations is unnecessary and could 
cause needless controversy over when a transaction changes from hostile 
to friendly. Accordingly, the final regulations do not contain any 
special rules related to hostile acquisition attempts. The final 
regulations contain an example illustrating how the regulations apply 
in the context of a hostile acquisition attempt.
G. Documentation of Success-Based Fees
    Under the proposed regulations, a payment that is contingent on the 
successful closing of an acquisition facilitates the acquisition except 
to the extent that evidence clearly demonstrates that some portion of 
the payment is allocable to activities that do not facilitate the 
acquisition. The final regulations retain the success-based fee rule, 
but extend it to all transactions to which Sec.  1.263(a)-5 applies, 
instead of just acquisitive transactions. In addition, the final 
regulations eliminate the ``clearly demonstrates'' standard in favor of 
a rule providing that success-based fees facilitate a transaction 
except to the extent the taxpayer maintains sufficient documentation to 
establish that a portion of the fee is allocable to activities that do 
not facilitate the transaction. The regulations require that this 
documentation consist of more than a mere allocation between activities 
that facilitate the transaction and activities that do not facilitate 
the transaction.
H. Treatment of Capitalized Costs
    The final regulations provide that amounts required to be 
capitalized by an acquirer in a taxable acquisitive transaction are 
added to the basis of the acquired assets in an asset transaction or to 
the basis of the acquired stock in a stock transaction. Amounts 
required to be capitalized by the target in an acquisition of its 
assets in a taxable transaction are treated as a reduction of the 
target's amount realized on the disposition of its assets.
    The final regulations do not address the treatment of amounts 
required to be capitalized in certain other transactions to which Sec.  
1.263(a)-5 applies (for example, amounts required to be capitalized in 
tax-free transactions, costs of a target in a taxable stock acquisition 
and stock issuance costs). The IRS and Treasury Department intend to 
issue separate guidance to address the treatment of these amounts and 
will consider at that time whether such amounts should be eligible for 
the 15-year safe harbor amortization period described in Sec.  
1.167(a)-3.

IV. Effective Dates and Changes in Methods of Accounting

    The final regulations under Sec. Sec.  1.263(a)-4 and 1.263(a)-5 
apply to amounts paid or incurred on or after December 31, 2003. Except 
as provided below regarding changes to a pooling method authorized by 
these regulations, a taxpayer seeking to change a method of accounting 
to comply with the final regulations must make the change on a modified 
cut-off basis, taking into account for purposes of section 481(a) only 
amounts paid or incurred in taxable years ending on or after January 
24, 2002 (the date of publication of the advance notice of proposed 
rulemaking in the Federal Register).
    As explained in the preamble to the proposed regulations, the IRS 
and Treasury Department are concerned that an unrestricted section 
481(a) adjustment for changes in methods of accounting made to comply 
with these regulations would create administrative burdens on taxpayers 
and the IRS. In addition, many of the simplification conventions in the 
final regulations (including the 12-month rule and the rules for 
employee compensation, overhead and de minimis costs) represent a 
change in the position traditionally taken by the IRS and the Treasury 
Department in interpreting section 263(a). However, the IRS and 
Treasury Department also want to reduce the potential for inconsistent 
treatment of conservative and aggressive taxpayers. Allowing a section 
481(a) adjustment for amounts paid or incurred in taxable years ending 
on or after the date of the advance notice of proposed rulemaking 
achieves the best balance of these concerns.
    For changes relating to the use of a pooling method under Sec.  
1.263(a)-4, taxpayers must apply a cut-off method. Applying a cut-off 
method reduces the burden on taxpayers of having to determine which 
assets fit into a pool on a retroactive basis.
    The preamble to the proposed regulations provides that taxpayers 
may not change a method of accounting in reliance upon the rules 
contained in the proposed regulations until the rules are published as 
final regulations. Nonetheless, the IRS has received numerous Forms 
3115 from taxpayers seeking the Commissioner's consent to change their 
method of accounting for items addressed in the advance notice of

[[Page 444]]

proposed rulemaking or in the proposed regulations. The IRS suspended 
processing of these requests pending publication of these final 
regulations. Upon publication of the final regulations, the IRS intends 
to process these requests in a manner consistent with the rules 
contained in the final regulations, including the effective date rules 
and rules relating to the computation of the section 481(a) adjustment. 
For example, if the change is requested for a taxable year ending prior 
to the effective date of the final regulations and concerns a method of 
accounting that the Commissioner does not recognize as permissible 
prior to the effective date of the final regulations, the IRS intends 
to reject the request. Similarly, if the change is requested for a 
taxable year ending on or after the effective date of the final 
regulations and concerns a method of accounting that is permissible 
under the final regulations, the IRS intends to return the request to 
the taxpayer (and refund the user fee) and advise the taxpayer to 
utilize the automatic consent procedures as authorized by the final 
regulations. Subsequent to the publication of these final regulations, 
the IRS may issue additional guidance for utilizing the automatic 
consent procedures as authorized by these regulations. Unless these 
regulations specifically identify a treatment of amounts as a method of 
accounting (for example, the safe harbor pooling methods), nothing in 
these regulations is intended to address whether the treatment of 
amounts to which these regulations apply constitutes a method of 
accounting.

V. Explanation of Amendments to Sec.  1.167(a)-3

    The final regulations essentially retain the amendments to Sec.  
1.167(a)-3 as contained in the proposed regulations. The final 
regulations provide that those amendments are effective for intangible 
assets created on or after the date the final regulations are published 
in the Federal Register.

Special Analyses

    It has been determined that this Treasury decision 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. It is hereby 
certified that the collection of information requirement in these 
regulations will not have a significant economic impact on a 
substantial number of small entities. This certification is based on 
the fact that the regulations merely require a taxpayer to retain 
records substantiating amounts paid in the process of investigating or 
otherwise pursuing certain transactions involving the acquisition of a 
trade or business. Therefore, a Regulatory Flexibility Analysis is not 
required. Pursuant to section 7805(f) of the Code, the notice of 
proposed rulemaking preceding this regulation was submitted to the 
Chief Counsel for Advocacy of the Small Business Administration for 
comment on its impact on small business. The Chief Counsel for Advocacy 
did not submit any comments on the regulations.

Drafting Information

    The principal author of these final 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

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART I--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *.


0
Par. 2. Section 1.167(a)-3 is amended by:
0
1. Designating the text of the section as paragraph (a) and adding a 
heading to newly designated paragraph (a).
0
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) 
Useful life. Solely 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 or useful life for the intangible asset 
is specifically prescribed or prohibited by the Internal Revenue Code, 
the regulations thereunder (other than by this paragraph (b)), or other 
published guidance in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2) of this chapter);
    (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 the length of which 
can be estimated with reasonable accuracy; 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 solely 
for purposes of determining the depreciation allowance referred to in 
paragraph (a) of this section.
    (2) Applicability to acquisitions of a trade or business, changes 
in the capital structure of a business entity, and certain other 
transactions. The safe harbor useful life provided by paragraph (b)(1) 
of this section does not apply to an amount required to be capitalized 
by Sec.  1.263(a)-5 (relating to amounts paid to facilitate an 
acquisition of a trade or business, a change in the capital structure 
of a business entity, and certain other transactions).
    (3) Depreciation method. A taxpayer that determines its 
depreciation allowance for an intangible asset using the 15-year useful 
life prescribed by paragraph (b)(1) of this section (or the 25-year 
useful life 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 useful life 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.
    (4) Effective date. This paragraph (b) applies to intangible assets 
created on or after December 31, 2003.

0
Par. 3. Section 1.263(a)-0 is added to read as follows:


Sec.  1.263(a)-0  Table of contents.

    This section lists captioned paragraphs contained in Sec. Sec.  
1.263(a)-1 through 1.263(a)-5.


[[Page 445]]




Sec.  1.263(a)-1  Capital expenditures; in general.


Sec.  1.263(a)-2  Examples of capital expenditures.


Sec.  1.263(a)-3  Election to deduct or capitalize certain 
expenditures.


Sec.  1.263(a)-4  Amounts paid to acquire or create intangibles.

    (a) Overview.
    (b) Capitalization with respect to intangibles.
    (1) In general.
    (2) Published guidance.
    (3) Separate and distinct intangible asset.
    (i) Definition.
    (ii) Creation or termination of contract rights.
    (iii) Amounts paid in performing services.
    (iv) Creation of computer software.
    (v) Creation of package design.
    (4) Coordination with other provisions of the Internal Revenue 
Code.
    (i) In general.
    (ii) Example.
    (c) Acquired intangibles.
    (1) In general.
    (2) Readily available software.
    (3) Intangibles acquired from an employee.
    (4) Examples.
    (d) Created intangibles.
    (1) In general.
    (2) Financial interests.
    (i) In general.
    (ii) Amounts paid to create, originate, enter into, renew or 
renegotiate.
    (iii) Renegotiate.
    (iv) Coordination with other provisions of this paragraph (d).
    (v) Coordination with Sec.  1.263(a)-5.
    (vi) Examples.
    (3) Prepaid expenses.
    (i) In general.
    (ii) Examples.
    (4) Certain memberships and privileges.
    (i) In general.
    (ii) Examples.
    (5) Certain rights obtained from a government agency.
    (i) In general.
    (ii) Examples.
    (6) Certain contract rights.
    (i) In general.
    (ii) Amounts paid to create, originate, enter into, renew or 
renegotiate.
    (iii) Renegotiate.
    (iv) Right.
    (v) De minimis amounts.
    (vi) Exception for lessee construction allowances.
    (vii) Examples.
    (7) Certain contract terminations.
    (i) In general.
    (ii) Certain break-up fees.
    (iii) Examples.
    (8) Certain benefits arising from the provision, production, or 
improvement of real property.
    (i) In general.
    (ii) Exclusions.
    (iii) Real property.
    (iv) Impact fees and dedicated improvements.
    (v) Examples.
    (9) Defense or perfection of title to intangible property.
    (i) In general.
    (ii) Certain break-up fees.
    (iii) Example.
    (e) Transaction costs.
    (1) Scope of facilitate.
    (i) In general.
    (ii) Treatment of termination payments.
    (iii) Special rule for contracts.
    (iv) Borrowing costs.
    (v) Special rule for stock redemption costs of open-end regulated 
investment companies.
    (2) Coordination with paragraph (d) of this section.
    (3) Transaction.
    (4) Simplifying conventions.
    (i) In general.
    (ii) Employee compensation.
    (iii) De minimis costs.
    (iv) Election to capitalize.
    (5) Examples.
    (f) 12-month rule.
    (1) In general.
    (2) Duration of benefit for contract terminations.
    (3) Inapplicability to created financial interests and self-created 
amortizable section 197 intangibles.
    (4) Inapplicability to rights of indefinite duration.
    (5) Rights subject to renewal.
    (i) In general.
    (ii) Reasonable expectancy of renewal.
    (iii) Safe harbor pooling method.
    (6) Coordination with section 461.
    (7) Election to capitalize.
    (8) Examples.
    (g) Treatment of capitalized costs.
    (1) In general.
    (2) Financial instruments.
    (h) Special rules applicable to pooling.
    (1) In general.
    (2) Method of accounting.
    (3) Adopting or changing to a pooling method.
    (4) Definition of pool.
    (5) Consistency requirement.
    (6) Additional guidance pertaining to pooling.
    (7) Example.
    (i) [Reserved].
    (j) Application to accrual method taxpayers.
    (k) Treatment of related parties and indirect payments.
    (l) Examples.
    (m) Amortization.
    (n) Intangible interests in land [Reserved]
    (o) Effective date.
    (p) Accounting method changes.
    (1) In general.
    (2) Scope limitations.
    (3) Section 481(a) adjustment.


Sec.  1.263(a)-5  Amounts paid or incurred to facilitate an acquisition 
of a trade or business, a change in the capital structure of a business 
entity, and certain other transactions.

    (a) General rule.
    (b) Scope of facilitate.
    (1) In general.
    (2) Ordering rules.
    (c) Special rules for certain costs.
    (1) Borrowing costs.
    (2) Costs of asset sales.
    (3) Mandatory stock distributions.
    (4) Bankruptcy reorganization costs.
    (5) Stock issuance costs of open-end regulated investment 
companies.
    (6) Integration costs.
    (7) Registrar and transfer agent fees for the maintenance of 
capital stock records.
    (8) Termination payments and amounts paid to facilitate mutually 
exclusive transactions.
    (d) Simplifying conventions.
    (1) In general.
    (2) Employee compensation.
    (i) In general.
    (ii) Certain amounts treated as employee compensation.
    (3) De minimis costs.
    (i) In general.
    (ii) Treatment of commissions.
    (4) Election to capitalize.
    (e) Certain acquisitive transactions.
    (1) In general.
    (2) Exception for inherently facilitative amounts.
    (3) Covered transactions.
    (f) Documentation of success-based fees.
    (g) Treatment of capitalized costs.
    (1) Tax-free acquisitive transactions [Reserved].
    (2) Taxable acquisitive transactions.
    (i) Acquirer.
    (ii) Target.
    (3) Stock issuance transactions [Reserved].
    (4) Borrowings.
    (5) Treatment of capitalized amounts by option writer.
    (h) Application to accrual method taxpayers.
    (i) [Reserved].
    (j) Coordination with other provisions of the Internal Revenue 
Code.
    (k) Treatment of indirect payments.
    (l) Examples.
    (m) Effective date.

[[Page 446]]

    (n) Accounting method changes.
    (1) In general.
    (2) Scope limitations.
    (3) Section 481(a) adjustment.


0
Par. 4. Sections 1.263(a)-4 and 1.263(a)-5 are added to read as 
follows:


Sec.  1.263((A)-4   Amounts paid to acquire or create intangibles.

    (a) Overview. This section provides rules for applying section 
263(a) to amounts paid to acquire or create intangibles. 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 or create 
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. 
Paragraph (p) of this section provides rules applicable to changes in 
methods of accounting made to comply with this section.
    (b) Capitalization with respect to intangibles--(1) In general. 
Except as otherwise provided in this section, a taxpayer must 
capitalize--
    (i) An amount paid to acquire an intangible (see paragraph (c) of 
this section);
    (ii) An amount paid to create an intangible described in paragraph 
(d) of this section;
    (iii) An amount paid to create or enhance a separate and distinct 
intangible asset within the meaning of paragraph (b)(3) of this 
section;
    (iv) An amount paid to create or enhance a future benefit 
identified in published guidance in the Federal Register or in the 
Internal Revenue Bulletin (see Sec.  601.601(d)(2)(ii) of this chapter) 
as an intangible for which capitalization is required under this 
section; and
    (v) An amount paid to facilitate (within the meaning of paragraph 
(e)(1) of this section) an acquisition or creation of an intangible 
described in paragraph (b)(1)(i), (ii), (iii) or (iv) of this section.
    (2) Published guidance. Any published guidance identifying a future 
benefit as an intangible for which capitalization is required under 
paragraph (b)(1)(iv) 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, Federal or foreign law and the 
possession and control of which is intrinsically capable of being sold, 
transferred or pledged (ignoring any restrictions imposed on 
assignability) separate and apart from a trade or business. In 
addition, for purposes of this section, a fund (or similar account) is 
treated as a separate and distinct intangible asset of the taxpayer if 
amounts in the fund (or account) may revert to the taxpayer. The 
determination of whether a payment creates a separate and distinct 
intangible asset is made based on all of the facts and circumstances 
existing during the taxable year in which the payment is made.
    (ii) Creation or termination of contract rights. Amounts paid to 
another party to create, originate, enter into, renew or renegotiate an 
agreement with that party that produces rights or benefits for the 
taxpayer (and amounts paid to facilitate the creation, origination, 
enhancement, renewal or renegotiation of such an agreement) are treated 
as amounts that do not create (or facilitate the creation of) a 
separate and distinct intangible asset within the meaning of this 
paragraph (b)(3). Further, amounts paid to another party to terminate 
(or facilitate the termination of) an agreement with that party are 
treated as amounts that do not create a separate and distinct 
intangible asset within the meaning of this paragraph (b)(3). See 
paragraphs (d)(2), (d)(6), and (d)(7) of this section for rules that 
specifically require capitalization of amounts paid to create or 
terminate certain agreements.
    (iii) Amounts paid in performing services. Amounts paid in 
performing services under an agreement are treated as amounts that do 
not create a separate and distinct intangible asset within the meaning 
of this paragraph (b)(3), regardless of whether the amounts result in 
the creation of an income stream under the agreement.
    (iv) Creation of computer software. Except as otherwise provided in 
the Internal Revenue Code, the regulations thereunder, or other 
published guidance in the Federal Register or in the Internal Revenue 
Bulletin (see Sec.  601.601(d)(2)(ii) of this chapter), amounts paid to 
develop computer software are treated as amounts that do not create a 
separate and distinct intangible asset within the meaning of this 
paragraph (b)(3).
    (v) Creation of package design. Amounts paid to develop a package 
design are treated as amounts that do not create a separate and 
distinct intangible asset within the meaning of this paragraph (b)(3). 
For purposes of this section, the term package design means the 
specific graphic arrangement or design of shapes, colors, words, 
pictures, lettering, and other elements on a given product package, or 
the design of a container with respect to its shape or function.
    (4) Coordination with other provisions of the Internal Revenue 
Code--(i) In general. Nothing in this section changes the treatment of 
an amount that is specifically provided for under any other provision 
of the Internal Revenue Code (other than section 162(a) or 212) or the 
regulations thereunder.
    (ii) Example. The following example illustrates the rule of this 
paragraph (b)(4):

    Example. On January 1, 2004, G enters into an interest rate swap 
agreement with unrelated counterparty H under which, for a term of 
five years, G is obligated to make annual payments at 11% and H is 
obligated to make annual payments at LIBOR on a notional principal 
amount of $100 million. At the time G and H enter into this swap 
agreement, the rate for similar on-market swaps is LIBOR to 10%. To 
compensate for this difference, on January 1, 2004, H pays G a yield 
adjustment fee of $3,790,786. This yield adjustment fee constitutes 
an amount paid to create an intangible and would be capitalized 
under paragraph (d)(2) of this section. However, because the yield 
adjustment fee is a nonperiodic payment on a notional principal 
contract as defined in Sec.  1.446-3(c), the treatment of this fee 
is governed by Sec.  1.446-3 and not this section.

    (c) Acquired intangibles--(1) In general. A taxpayer must 
capitalize amounts paid to another party to acquire any intangible from 
that party in a purchase or similar transaction. Examples of 
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 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

[[Page 447]]

intangible treated as debt for federal income tax purposes.
    (iii) A financial instrument, such as--
    (A) A notional principal contract;
    (B) A foreign currency contract;
    (C) A futures contract;
    (D) 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, regardless of whether the 
taxpayer provides or acquires the property));
    (E) 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, regardless of whether the taxpayer provides or acquires 
the property)); and
    (F) Any other financial derivative.
    (iv) An endowment contract, annuity contract, or insurance 
contract.
    (v) Non-functional currency.
    (vi) A lease.
    (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 
that is not treated for Federal income tax purposes as a stripped 
coupon).
    (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.
    (xv) An agreement providing either party the right to use, possess 
or sell an intangible described in paragraphs (c)(1)(i) through (v) of 
this section.
    (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 includible in 
the employee's income in connection with the performance of services 
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. Debt 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 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. 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 an intangible 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 an intangible described 
in this paragraph (d). The determination of whether an amount is paid 
to create an intangible described in this paragraph (d) is to be made 
based on all of the facts and circumstances, disregarding distinctions 
between the labels used in this paragraph (d) to describe the 
intangible and the labels used by the taxpayer and other parties to the 
transaction.
    (2) Financial interests--(i) In general. A taxpayer must capitalize 
amounts paid to another party to create, originate, enter into, renew 
or renegotiate 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 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, such as--
    (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, regardless of whether the 
taxpayer provides or acquires the 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, regardless of whether the taxpayer provides or acquires 
the 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.
    (F) An agreement providing either party the right to use, possess 
or sell a financial interest described in this paragraph (d)(2).
    (ii) Amounts paid to create, originate, enter into, renew or 
renegotiate. An amount paid to another party is not paid to create, 
originate, enter into, renew or renegotiate a financial interest with 
that party if the payment is made with the mere hope or expectation of 
developing or maintaining a business relationship with that party and 
is not contingent on the origination, renewal or renegotiation of a 
financial interest with that party.
    (iii) Renegotiate. A taxpayer is treated as renegotiating a 
financial interest if the terms of the financial interest are modified. 
A taxpayer also is treated as renegotiating a financial interest if the 
taxpayer enters into a new financial interest with the same party (or 
substantially the same parties) to a terminated financial interest, the 
taxpayer could not cancel the terminated financial interest without the 
consent of the other party (or parties), and the other party (or 
parties) would not have consented to the cancellation unless the 
taxpayer entered into the new financial interest. A taxpayer is treated 
as unable to cancel a financial interest without the consent of the 
other party

[[Page 448]]

(or parties) if, under the terms of the financial interest, the 
taxpayer is subject to a termination penalty and the other party (or 
parties) to the financial interest modifies the terms of the penalty.
    (iv) 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).
    (v) Coordination with Sec.  1.263(a)-5. See Sec.  1.263(a)-5 for 
the treatment of borrowing costs and the treatment of amounts paid by 
an option writer.
    (vi) 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 principal amount of $250,000. The $250,000 principal 
amount of the loan paid to A constitutes an amount paid to another 
party to create a debt instrument with that party under paragraph 
(d)(2)(i)(B) of this section 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. Y's 
payment of $1,000,000 to W constitutes an amount paid to another 
party to create an option with that party under paragraph 
(d)(2)(i)(C)(7) of this section 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. 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 
under paragraph (d)(2)(i)(A) of this section and must be 
capitalized.
    Example 4. Take or pay contract. Q corporation, a producer of 
natural gas, pays $1,000,000 to R during 2005 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. Q's payment 
of $1,000,000 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) under paragraph 
(d)(2)(i)(C)(6) of this section and must be capitalized.
    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. 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 under paragraph (d)(2)(i)(C)(6) of this section and 
must be capitalized.
    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 or obligation to provide property and 
does not create a separate and distinct intangible asset for S 
within the meaning of paragraph (b)(3)(i) of this section.

    (3) Prepaid expenses--(i) In general. A taxpayer must capitalize 
prepaid expenses.
    (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 three years of 
coverage under a property and casualty insurance policy. The $10,000 
is a prepaid expense and must be capitalized under this paragraph 
(d)(3). Paragraph (d)(2) of this section does not apply to the 
payment because the policy has no cash value.
    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 a prepaid expense 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, renew, 
renegotiate, or upgrade a membership or privilege from that 
organization. A taxpayer is not required to capitalize under this 
paragraph (d)(4) an amount paid to obtain, renew, renegotiate or 
upgrade 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 trade association. 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, renew, renegotiate, or upgrade its rights under 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 create, originate, enter into, renew or 
renegotiate with that party--
    (A) An agreement providing the taxpayer the right to use tangible 
or intangible property or the right to be compensated for the use of 
tangible or intangible property;
    (B) An agreement providing the taxpayer the right to provide or to 
receive services (or the right to be compensated for services 
regardless of whether the taxpayer provides such services);
    (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);

[[Page 449]]

    (D) An agreement not to acquire additional ownership interests in 
the taxpayer; or
    (E) An agreement providing the taxpayer (as the covered party) with 
an annuity, an endowment, or insurance coverage.
    (ii) Amounts paid to create, originate, enter into, renew or 
renegotiate. An amount paid to another party is not paid to create, 
originate, enter into, renew or renegotiate an agreement with that 
party if the payment is made with the mere hope or expectation of 
developing or maintaining a business relationship with that party and 
is not contingent on the origination, renewal or renegotiation of an 
agreement with that party.
    (iii) Renegotiate. A taxpayer is treated as renegotiating an 
agreement if the terms of the agreement are modified. A taxpayer also 
is treated as renegotiating an agreement if the taxpayer enters into a 
new agreement with the same party (or substantially the same parties) 
to a terminated agreement, the taxpayer could not cancel the terminated 
agreement without the consent of the other party (or parties), and the 
other party (or parties) would not have consented to the cancellation 
unless the taxpayer entered into the new agreement. A taxpayer is 
treated as unable to cancel an agreement without the consent of the 
other party (or parties) if, under the terms of the agreement, the 
taxpayer is subject to a termination penalty and the other party (or 
parties) to the agreement modifies the terms of the penalty.
    (iv) Right. An agreement does not provide the taxpayer a right to 
use property or to provide or receive services if the agreement may be 
terminated at will by the other party (or parties) to the agreement 
before the end of the period prescribed by paragraph (f)(1) of this 
section. An agreement is not terminable at will if the other party (or 
parties) to the agreement is economically compelled not to terminate 
the agreement until the end of the period prescribed by paragraph 
(f)(1) of this section. All of the facts and circumstances will be 
considered in determining whether the other party (or parties) to an 
agreement is economically compelled not to terminate the agreement. An 
agreement also does not provide the taxpayer the right to provide 
services if the agreement merely provides that the taxpayer will stand 
ready to provide services if requested, but places no obligation on 
another person to request or pay for the taxpayer's services.
    (v) De minimis amounts. A taxpayer is not required to capitalize 
amounts paid to another party (or parties) to create, originate, enter 
into, renew or renegotiate with that party (or those parties) 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. For 
purposes of this paragraph (d)(6), an amount paid in the form of 
property is valued at its fair market value at the time of the payment. 
In general, a taxpayer must determine whether the rules of this 
paragraph (d)(6)(v) apply by accounting for the specific amounts paid 
with respect to each agreement. However, a taxpayer that reasonably 
expects to create, originate, enter into, renew or renegotiate at least 
25 similar agreements during the taxable year may establish a pool of 
agreements for purposes of determining the amounts paid with respect to 
the agreements in the pool. Under this pooling method, the amount 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.
    (vi) Exception for 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 to the extent the lessee expends 
the amount for the tangible property that is owned by the lessor for 
Federal income tax purposes (see, for example, section 110).
    (vii) 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 Z, the 
owner of the commercial property, $50,000 in exchange for Z entering 
into a 10-year lease with V. V's payment is an amount paid to 
another 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)(v) 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 existing 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 
another party 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)(v) of this section. Under paragraph (d)(6)(i)(A) of this 
section, Y must capitalize the entire $50,000 payment.
    Example 3. Modification of lease agreement. In 2004, R enters 
into a 5-year, non-cancelable lease of a mainframe computer for use 
in its business. R subsequently determines that the mainframe 
computer that R is leasing is no longer adequate for its needs. In 
2006, R and P corporation (the lessor) agree to terminate the 2004 
lease and to enter into a new 5-year lease for a different and more 
powerful mainframe computer. R pays P a $75,000 early termination 
fee. P would not have agreed to terminate the 2004 lease unless R 
agreed to enter into the 2006 lease. R's payment of $75,000 is an 
amount paid to another party to renegotiate an agreement providing R 
the right to use property. Because the $75,000 payment exceeds 
$5,000, no portion of the amount paid to P is de minimis for 
purposes of paragraph (d)(6)(v) of this section. Under paragraph 
(d)(6)(i)(A) of this section, R must capitalize the entire $75,000 
payment.
    Example 4. Modification of lease agreement. Same as Example 3, 
except the 2004 lease agreement allows R to terminate the lease at 
any time subject to a $75,000 early termination fee. Because R can 
terminate the lease without P's approval, R's payment of $75,000 is 
not an amount paid to another party to renegotiate an agreement. 
Accordingly, R is not required to capitalize the $75,000 payment 
under this paragraph (d)(6).
    Example 5. Modification of lease agreement. Same as Example 4, 
except P agreed to reduce the early termination fee to $60,000. 
Because R did not pay an amount to renegotiate the early termination 
fee, R's payment of $60,000 is not an amount paid to another party 
to renegotiate an agreement. Accordingly, R is not required to 
capitalize the $60,000 payment under this paragraph (d)(6).
    Example 6. 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 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)(v) of this section. Under paragraph 
(d)(6)(i)(C) of this section, R must capitalize the entire $100,000 
payment.
    Example 7. Standstill agreement. During 2004 through 2005, X 
corporation acquires a large minority interest in the stock of Z 
corporation. To ensure that X does not take control of Z, Z pays X 
$5,000,000 for a

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standstill agreement under which X agrees not to acquire any more 
stock in Z for a period of 10 years. Z's payment is an amount paid 
to another party to enter into an agreement not to acquire 
additional ownership interests in Z. Because the $5,000,000 payment 
exceeds $5,000, no portion of the amount paid to X is de minimis for 
purposes of paragraph (d)(6)(v) of this section. Under paragraph 
(d)(6)(i)(D) of this section, Z must capitalize the entire 
$5,000,000 payment.
    Example 8. Signing bonus. Employer B pays a $25,000 signing 
bonus to employee C to induce C to come to work for B. C can leave 
B's employment at any time to work for a competitor of B and is not 
required to repay the $25,000 bonus to B. Because C is not 
economically compelled to continue his employment with B, B's 
payment does not provide B the right to receive services from C. 
Accordingly, B is not required to capitalize the $25,000 payment.
    Example 9. Renewal. In 2000, M corporation and N corporation 
enter into a 5-year agreement that gives M the right to manage N's 
investment portfolio. In 2005, N has the option of renewing the 
agreement for another three years. During 2004, M pays $10,000 to 
send several employees of N to an investment seminar. M pays the 
$10,000 to help develop and maintain its business relationship with 
N with the expectation that N will renew its agreement with M in 
2005. Because M's payment is not contingent on N agreeing to renew 
the agreement, M's payment is not an amount paid to renew an 
agreement under paragraph (d)(6)(ii) of this section and is not 
required to be capitalized.
    Example 10. 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 non-
cancelable telecommunications contract, X provides B with a free 
wireless telephone. The fair market value of the wireless telephone 
is $300 at the time it is provided to B. 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)(v) 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 (other than an intangible described in paragraph 
(c)(1)(i) through (iv) of this section or a financial interest 
described in paragraph (d)(2) of this section); 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) Certain break-up fees. Paragraph (d)(7)(i) of this section 
does not apply to the termination of a transaction described in Sec.  
1.263(a)-5(a) (relating to an acquisition of a trade or business, a 
change in the capital structure of a business entity, and certain other 
transactions). See Sec.  1.263(a)-5(c)(8) for rules governing the 
treatment of amounts paid to terminate a transaction to which that 
section applies.
    (iii) Examples. The following examples illustrate the rules of this 
paragraph (d)(7):

    Example 1. Termination of exclusive license agreement. On July 
1, 2005, 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, 2007, 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, 2005, 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, 2008, 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, 2005, 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, 2007, 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 merger agreement. N corporation and U 
corporation enter into an agreement under which N agrees to merge 
into U. Subsequently, N pays U $10,000,000 to terminate the merger 
agreement. As provided in paragraph (d)(7)(ii) of this section, N's 
$10,000,000 payment to terminate the merger agreement with U is not 
required to be capitalized under this paragraph (d)(7). In addition, 
N's $10,000,000 does not create a separate and distinct intangible 
asset for N within the meaning of paragraph (b)(3)(i) of this 
section. (See Sec.  1.263(a)-5 for additional rules regarding 
termination of merger agreements).

    (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 if the taxpayer transfers 
ownership of the real property to another person (except to the extent 
the real property is sold for fair market value) and if the real 
property can reasonably be expected to produce significant economic 
benefits to the taxpayer after the transfer. A taxpayer also must 
capitalize amounts paid to produce or improve real property owned by 
another (except to the extent the taxpayer is selling services at fair 
market value to produce or improve the real property) 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 if the taxpayer transfers 
real property or pays an amount to produce or improve real property 
owned by another in exchange for services, the purchase or use of 
property, or the creation of an intangible described in paragraph (d) 
of this section (other than in this paragraph (d)(8)). The preceding 
sentence does not apply to the extent the taxpayer does not receive 
fair market value consideration for the real property that is 
relinquished or for the amounts that are paid by the taxpayer to 
produce or improve real property owned by another.
    (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

[[Page 451]]

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 
constructing a publicly owned bridge capable of accommodating W's 
trucks. W's payment to city Z is an amount paid to produce or 
improve 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. Transfer of real property to another. K corporation, 
a shipping company, uses smaller vessels to unload its ocean-going 
vessels at port X. There is no natural harbor at port X, and during 
stormy weather the transfer of freight between K's ocean vessels and 
port X is extremely difficult and sometimes impossible, which can be 
very costly to K. Consequently, K constructs a short breakwater at a 
cost of $50,000. The short breakwater, however, is inadequate, so K 
persuades the port authority to build a larger breakwater that will 
allow K to unload its vessels at any time of the year and during all 
kinds of weather. K contributes the short breakwater and pays 
$200,000 to the port authority for use in building the larger 
breakwater. Because the transfer of the small breakwater and 
$200,000 is reasonably expected to produce significant economic 
benefits for K, K must capitalize both the adjusted basis of the 
small breakwater (determined at the time the small breakwater is 
contributed) and the $200,000 payment under this paragraph (d)(8).
    Example 3. 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 if that other party 
challenges the taxpayer's title to the intangible property.
    (ii) Certain break-up fees. Paragraph (d)(9)(i) of this section 
does not apply to the termination of a transaction described in Sec.  
1.263(a)-5(a) (relating to an acquisition of a trade or business, a 
change in the capital structure of a business entity, and certain other 
transactions). See Sec.  1.263(a)-5 for rules governing the treatment 
of amounts paid to terminate a transaction to which that section 
applies. Paragraph (d)(9)(i) of this section also does not apply to an 
amount paid to another party to terminate an agreement that grants that 
party the right to purchase the taxpayer's intangible property.
    (iii) 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. 
Except as otherwise provided in this section, an amount is paid to 
facilitate the acquisition or creation of an intangible (the 
transaction) if the amount is paid in the process of investigating or 
otherwise pursuing the transaction. Whether an amount is paid in the 
process of investigating or otherwise pursuing the transaction is 
determined based on all of the facts and circumstances. In determining 
whether an amount is paid to facilitate a transaction, the fact that 
the amount would (or would not) have been paid but for the transaction 
is relevant, but is not determinative. An amount paid to determine the 
value or price of an intangible is an amount paid in the process of 
investigating or otherwise pursuing the transaction.
    (ii) Treatment of termination payments. An amount paid to terminate 
(or acilitate the termination of) an existing agreement does not 
facilitate the acquisition or creation of another agreement under this 
section. See paragraph (d)(6)(iii) of this section for the treatment of 
termination fees paid to the other party (or parties) of a renegotiated 
agreement.
    (iii) Special rule for contracts. An amount is treated as not paid 
in the process of investigating or otherwise pursuing the creation of 
an agreement described in paragraph (d)(2) or (d)(6) of this section if 
the amount relates to activities performed before the earlier of the 
date the taxpayer begins preparing its bid for the agreement or the 
date the taxpayer begins discussing or negotiating the agreement with 
another party to the agreement.
    (iv) Borrowing costs. An amount paid to facilitate a borrowing does 
not facilitate an acquisition or creation of an intangible described in 
paragraphs (b)(1)(i) through (iv) of this section. See Sec. Sec.  
1.263(a)-5 and 1.446-5 for the treatment of an amount paid to 
facilitate a borrowing.
    (v) Special rule for stock redemption costs of open-end regulated 
investment companies. An amount paid by an open-end regulated 
investment company (within the meaning of section 851) to facilitate a 
redemption of its stock is treated as an amount that does not 
facilitate the acquisition of an intangible under this section.
    (2) Coordination with paragraph (d) of this section. In the case of 
an amount paid to facilitate the creation 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.
    (3) Transaction. For purposes of this section, the term transaction 
means all of the factual elements comprising an acquisition or creation 
of an intangible 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. For example, a purchase of intangibles 
under one purchase agreement constitutes a single transaction, 
notwithstanding the fact that the acquisition involves multiple 
intangibles and the amounts paid to facilitate the acquisition are 
capable of being allocated among the various intangibles acquired.
    (4) Simplifying conventions--(i) In general. For purposes of this 
section, employee compensation (within the meaning of paragraph 
(e)(4)(ii) of this section), overhead, and de minimis costs (within the 
meaning of paragraph (e)(4)(iii) of this section) are treated as 
amounts that do not facilitate the acquisition or creation of an 
intangible.
    (ii) Employee compensation--(A) In general. The term employee 
compensation means compensation (including salary, bonuses and 
commissions) paid to an employee of the taxpayer. For purposes of this

[[Page 452]]

section, whether an individual is an employee is determined in 
accordance with the rules contained in section 3401(c) and the 
regulations thereunder.
    (B) Certain amounts treated as employee compensation. For purposes 
of this section, a guaranteed payment to a partner in a partnership is 
treated as employee compensation. For purposes of this section, annual 
compensation paid to a director of a corporation is treated as employee 
compensation. For example, an amount paid to a director of a 
corporation for attendance at a regular meeting of the board of 
directors (or committee thereof) is treated as employee compensation 
for purposes of this section. However, an amount paid to a director for 
attendance at a special meeting of the board of directors (or committee 
thereof) is not treated as employee compensation. An amount paid to a 
person that is not an employee of the taxpayer (including the employer 
of the individual who performs the services) is treated as employee 
compensation for purposes of this section only if the amount is paid 
for secretarial, clerical, or similar administrative support services. 
In the case of an affiliated group of corporations filing a 
consolidated Federal income tax return, a payment by one member of the 
group to a second member of the group for services performed by an 
employee of the second member is treated as employee compensation if 
the services provided by the employee are provided at a time during 
which both members are affiliated.
    (iii) De minimis costs--(A) In general. Except as provided in 
paragraph (e)(4)(iii)(B) of this section, the term de minimis costs 
means amounts (other than employee compensation and overhead) paid in 
the process of investigating or otherwise pursuing a transaction if, in 
the aggregate, the amounts do not exceed $5,000 (or such greater amount 
as may be set forth in published guidance). If the amounts exceed 
$5,000 (or such greater amount as may be set forth in published 
guidance), none of the amounts are de minimis costs within the meaning 
of this paragraph (e)(4)(iii)(A). For purposes of this paragraph 
(e)(4)(iii), an amount paid in the form of property is valued at its 
fair market value at the time of the payment. In determining the amount 
of transaction costs paid in the process of investigating or otherwise 
pursuing a transaction, a taxpayer generally must account for the 
specific costs paid with respect to each transaction. However, a 
taxpayer that reasonably expects to enter into at least 25 similar 
transactions during the taxable year may establish a pool of similar 
transactions for purposes of determining the amount of transaction 
costs paid in the process of investigating or otherwise pursuing the 
transactions in the pool. Under this pooling method, the amount of 
transaction costs paid in the process of investigating or otherwise 
pursuing each transaction included in the pool is equal to the average 
transaction costs paid in the process of investigating or otherwise 
pursuing all transactions included in the pool. A taxpayer computes the 
average transaction costs paid in the process of investigating or 
otherwise pursuing all transactions included in the pool by dividing 
the sum of all transaction costs paid in the process of investigating 
or otherwise pursuing 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.
    (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, origination, entrance into, renewal or 
renegotiation of an intangible described in paragraph (d)(2)(i) of this 
section.
    (iv) Election to capitalize. A taxpayer may elect to treat employee 
compensation, overhead, or de minimis costs paid in the process of 
investigating or otherwise pursuing a transaction as amounts that 
facilitate the transaction. The election is made separately for each 
transaction and applies to employee compensation, overhead, or de 
minimis costs, or to any combination thereof. For example, a taxpayer 
may elect to treat overhead and de minimis costs, but not employee 
compensation, as amounts that facilitate the transaction. A taxpayer 
makes the election by treating the amounts to which the election 
applies as amounts that facilitate the transaction in the taxpayer's 
timely filed original Federal income tax return (including extensions) 
for the taxable year during which the amounts are paid. In the case of 
an affiliated group of corporations filing a consolidated return, the 
election is made separately with respect to each member of the group, 
and not with respect to the group as a whole. In the case of an S 
corporation or partnership, the election is made by the S corporation 
or by the partnership, and not by the shareholders or partners. An 
election made under this paragraph (e)(4)(iv) is revocable with respect 
to each taxable year for which made only with the consent of the 
Commissioner.
    (5) Examples. The following examples illustrate the rules of this 
paragraph (e):

    Example 1. Costs to facilitate. In December 2005, 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 2005 
for services rendered by A during December in assisting with 
negotiations with X. In January 2006, 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 2006 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)(4)(iii)(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)(4)(iii)(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)(v) of this section.
    Example 2. Costs to facilitate. Partnership X leases its 
manufacturing equipment from Y corporation under a 10-year lease. 
During 2005, 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. Under paragraph (e)(1)(ii), X's 
$50,000 payment does not facilitate the creation of the new lease 
with Z. In addition, X's $50,000 payment does not terminate an 
agreement described in paragraph (d)(7) of this section. 
Accordingly, X is not required to capitalize the $50,000 termination 
payment under this section.
    Example 3. 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 the creation of that 
agreement. As provided by paragraph (e)(2) 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.
    Example 4. Costs to facilitate. U corporation, which owns a 
majority of the common stock of T corporation, votes its controlling 
interest in favor of a perpetual extension of T's charter. M, a 
minority shareholder in T, votes against the extension. Under 
applicable state law, U is required to

[[Page 453]]

purchase the stock of T held by M. When U and M are unable to agree 
on the value of M's shares, U brings an action in state court to 
appraise the value of M's stock interest. U pays attorney, 
accountant and appraisal fees of $25,000 for services rendered in 
connection with the negotiation and litigation with M. Because U's 
attorney, accountant and appraisal costs help establish the purchase 
price of M's stock, U's $25,000 payment facilitates the acquisition 
of stock. Accordingly, U must capitalize the $25,000 payment under 
paragraph (b)(1)(v) of this section.
    Example 5. Costs to facilitate. For several years, H corporation 
has provided services to J corporation whenever requested by J. H 
wants to enter into a multiple-year contract with J that would give 
H the right to provide services to J. On June 10, 2004, H starts to 
prepare a bid to provide services to J and pays a consultant $15,000 
to research potential competitors. On August 10, 2004, H raises the 
possibility of a multi-year contract with J. On October 10, 2004, H 
and J enter into a contract giving H the right to provide services 
to J for five years. During 2004, H pays $7,000 to travel to the 
city in which J's offices are located to continue providing services 
to J under their prior arrangement and pays $6,000 for travel to the 
city in which J's offices are located to further develop H's 
business relationship with J (for example, to introduce new 
employees, update J on current developments and take J's executives 
to dinner). H also pays $8,000 for travel costs to meet with J to 
discuss and negotiate the contract. Because the contract gives H the 
right to provide services to J, H must capitalize amounts paid to 
facilitate the creation of the contract. The $7,000 of travel 
expenses paid to provide services to J under their prior arrangement 
does not facilitate the creation of the contract and is not required 
to be capitalized, regardless of when the travel occurs. The $6,000 
of travel expenses paid to further develop H's business relationship 
with J is paid in the process of pursuing the contract (and 
therefore must be capitalized) only to the extent the expenses 
relate to travel on or after June 10, 2004 (the date H begins to 
prepare a bid) and before October 11, 2004 (the date after H and J 
enter into the contract). The $8,000 of travel expenses paid to meet 
with J to discuss and negotiate the contract is paid in the process 
of pursuing the contact and must be capitalized. The $15,000 of 
consultant fees is paid to investigate the contract and also must be 
capitalized.
    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 of 
an intangible described in paragraph (d)(9) of 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. As 
part of the acquisition, W pays an independent appraiser a fee of 
$10,000 to appraise the portfolio. The fee is an amount paid to 
facilitate W's acquisition of an intangible. The acquisition of the 
loan portfolio is a single transaction within the meaning of 
paragraph (e)(3) of this section. Because the amount paid to 
facilitate the transaction exceeds $5,000, the amount is not de 
minimis as defined in paragraph (e)(4)(iii)(A) of this section. 
Accordingly, W must capitalize the $10,000 fee under paragraph 
(b)(1)(v) 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)(4)(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.
    (f) 12-month rule--(1) In general. Except as otherwise provided in 
this paragraph (f), a taxpayer is not required to capitalize under this 
section amounts paid to create (or to facilitate the creation of) any 
right or benefit for the taxpayer that does not extend beyond the 
earlier of--
    (i) 12 months after the first date on which the taxpayer realizes 
the right or benefit; or
    (ii) The end of the taxable year following the taxable year in 
which the payment is made.
    (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 that lasts for the unexpired term of the 
agreement immediately before the date of the termination. If the terms 
of a contract or other agreement described in paragraph (d)(7)(i) of 
this section permit the taxpayer to terminate the contract or agreement 
after a notice period, amounts paid by the taxpayer to terminate the 
contract or agreement before the end of the notice period create a 
benefit for the taxpayer that lasts for the amount of time by which the 
notice period is shortened.
    (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 facilitate the creation 
of) an intangible described in paragraph (d)(2) of this section 
(relating to amounts paid to create financial interests) or to amounts 
paid to create (or facilitate the creation of) an intangible 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 
facilitate the creation of) an intangible 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) of this section, the duration of a right includes any 
renewal period if all of the facts and circumstances in existence 
during the taxable year in which the right is created 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 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 $14,000 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 for 
the taxpayer to earn back its $14,000 payment 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

[[Page 454]]

available to others 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.
    (E) Terminations. The fact that similar rights are typically 
terminated prior to renewal is evidence of a lack of a reasonably 
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 during a taxable year, a 
taxpayer that reasonably expects to enter into at least 25 similar 
rights during the taxable year may establish a pool of similar rights 
for which the initial term does not extend beyond the period prescribed 
in paragraph (f)(1) of this section and may elect to apply the 
reasonable expectancy of renewal test to that 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 costs described in paragraph 
(d)(6)(v) of this section) paid to create the rights included in the 
pool and all amounts paid to facilitate the creation 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) 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) 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) of this section, all rights in the pool are treated as 
having a duration that extends beyond the period prescribed in 
paragraph (f)(1) 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) 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) of this 
section and the taxpayer must capitalize the resulting amount under 
this section by treating such amount as creating a separate intangible. 
The amount determined by multiplying the aggregate amount described in 
paragraph (f)(5)(iii)(A) of this section by the percentage of rights in 
the pool that are not reasonably expected to be renewed beyond the 
period prescribed in paragraph (f)(1) of this section is not required 
to be capitalized under this section.
    (6) 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 for rules relating to economic performance.
    (7) Election to capitalize. A taxpayer may elect not to apply the 
rule contained in paragraph (f)(1) of this section. An election made 
under this paragraph (f)(7) applies to all similar transactions during 
the taxable year to which paragraph (f)(1) of this section would apply 
(but for the election under this paragraph (f)(7)). For example, a 
taxpayer may elect under this paragraph (f)(7) to capitalize its costs 
of prepaying insurance contracts for 12 months, but may continue to 
apply the rule in paragraph (f)(1) to its costs of entering into non-
renewable, 12-month service contracts. A taxpayer makes the election by 
treating the amounts as capital expenditures in its timely filed 
original federal income tax return (including extensions) for the 
taxable year during which the amounts are paid. In the case of an 
affiliated group of corporations filing a consolidated return, the 
election is made separately with respect to each member of the group, 
and not with respect to the group as a whole. In the case of an S 
corporation or partnership, the election is made by the S corporation 
or by the partnership, and not by the shareholders or partners. An 
election made under this paragraph (f)(7) is revocable with respect to 
each taxable year for which made only with the consent of the 
Commissioner.
    (8) Examples. The rules of this paragraph (f) are illustrated by 
the following examples, in which it is assumed (unless otherwise 
stated) that the taxpayer is a calendar year, accrual method taxpayer 
that does not have a short taxable year in any taxable year and has not 
made an election under paragraph (f)(7) of this section:

    Example 1. Prepaid expenses. On December 1, 2005, N corporation 
pays a $10,000 insurance premium to obtain a property insurance 
policy (with no cash value) with a 1-year term that begins on 
February 1, 2006. The amount paid by N is a prepaid expense 
described in paragraph (d)(3) of this section and not paragraph 
(d)(2) 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. (i) Assume the same facts as in 
Example 1, except that the policy has a term beginning on December 
15, 2005. 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, 2005 
(the first date the benefit is realized by the taxpayer) nor beyond 
the end of the taxable year following the taxable year in which the 
payment is made. Accordingly, N is not required to capitalize the 
$10,000 payment.
    (ii) Alternatively, assume N capitalizes prepaid expenses for 
financial accounting and reporting purposes and elects under 
paragraph (f)(7) of this section not to apply the 12-month rule 
contained in paragraph (f)(1) of this section. N must capitalize the 
$10,000 payment for Federal income tax purposes.
    Example 3. Financial interests. On October 1, 2005, X 
corporation makes a 9-month loan to B in the principal amount of 
$250,000. The principal amount of the loan 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) 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, 2005, Y 
corporation 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) 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, 2005, R corporation pays 
$10,000 to state X to obtain

[[Page 455]]

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, 2005, and each of the succeeding four years. R 
pays the $500 fee on July 1 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 12 months after the first date 
on which R realizes the rights or benefits attributable to the 
payment and beyond the end of 2006 (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 taxable year. 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, 2005, W corporation 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, 
2005. 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 the lease as 
described in paragraph (e)(1)(i) of this section. The 12-month rule 
of this paragraph (f) applies to the $7,000 payment because the 
right or benefit that the $7,000 payment facilitates the creation of 
neither extends more than 12 months beyond December 1, 2005 (the 
first date the benefit is realized by the taxpayer) nor beyond the 
end of the taxable year following the taxable year in which the 
payment is made. Accordingly, W is not required to capitalize its 
payment to its outside counsel.
    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 and 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 that 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 end of the 
taxable year following the taxable year in which the payment is 
made. Accordingly, V is not required to capitalize the $100,000 
payment.
    Example 9. Certain contract terminations. Assume the same facts 
as in Example 7, except that either party can terminate the lease 
upon 12 months notice. When the lease has a remaining unexpired term 
of 5 years, V wants to terminate the lease, however, V does not want 
to wait another 12 months. V pays A $50,000 for the ability to 
terminate the lease with one month's notice. 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 11 months, the time by which the 
notice period is shortened. The 12-month rule of this paragraph (f) 
applies to V's $50,000 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 end of the taxable year following the taxable year in which the 
payment is made. Accordingly, V is not required to capitalize the 
$50,000 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 August 1, 2005, U prepays its office rent expense for the 
first six months of 2006 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 2006, U's prepaid rent 
is not incurred in 2005 and therefore is not properly taken into 
account through capitalization, deduction, or otherwise in 2005. 
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, 2006. 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, 
2005, for advertising and marketing services to be provided to N 
throughout calendar year 2006. 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 advertising expense does not 
occur until 2006, N's prepaid advertising expense is not incurred in 
2005 and therefore is not properly taken into account through 
capitalization, deduction, or otherwise in 2005. Thus, the rules of 
this paragraph (f) do not apply to N's payment.

    (g) Treatment of capitalized costs--(1) In general. An amount 
required to be capitalized by this section is not currently deductible 
under section 162. Instead, the amount generally is added to the basis 
of the intangible acquired or created. See section 1012.
    (2) Financial instruments. In the case of a financial instrument 
described in paragraph (c)(1)(iii) or (d)(2)(i)(C) of this section, 
notwithstanding paragraph (g)(1) of this section, if under other 
provisions of law the amount required to be capitalized is not required 
to be added to the basis of the intangible acquired or created, then 
the other provisions of law will govern the tax treatment of the 
amount.
    (h) Special rules applicable to pooling--(1) In general. Except as 
otherwise provided, the rules of this paragraph (h) apply to the 
pooling methods described in paragraph (d)(6)(v) of this section 
(relating to de minimis rules applicable to certain contract rights), 
paragraph (e)(4)(iii)(A) 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) Method of accounting. A pooling method authorized by this 
section constitutes a method of accounting for purposes of section 446. 
A taxpayer that adopts or changes to a pooling method authorized by 
this section must use the method for the year of adoption and for all 
subsequent taxable years during which the taxpayer qualifies to use the 
pooling method unless a change to another method is required by the 
Commissioner in order to clearly reflect income, or unless permission 
to change to another method is granted by the

[[Page 456]]

Commissioner as provided in Sec.  1.446-1(e).
    (3) Adopting or changing to a pooling method. A taxpayer adopts (or 
changes to) a pooling method authorized by this section for any taxable 
year 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), and by using the pooling 
method to compute its taxable income for the year of adoption (or 
change).
    (4) 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 
or service provided under a contract. However, a taxpayer that pools 
similar transactions, agreements or rights must include in the pool all 
similar transactions, agreements or rights created during the taxable 
year. For purposes of the pooling methods described in paragraph 
(d)(6)(v) of this section (relating to de minimis rules applicable to 
certain contract rights) and paragraph (e)(4)(iii)(A) of this section 
(relating to de minimis rules applicable to transaction costs), an 
agreement (or a transaction) is treated as not similar to other 
agreements (or transactions) included in the pool if the amount at 
issue with respect to that agreement (or transaction) is reasonably 
expected to differ significantly from the average amount at issue with 
respect to the other agreements (or transactions) properly included in 
the pool.
    (5) 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)(v) 
of this section (relating to de minimis rules applicable to certain 
contract rights) and paragraph (e)(4)(iii)(A) of this section (relating 
to de minimis rules 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)(v) of 
this section and paragraph (e)(4)(iii)(A) of this section as is used 
for purposes of paragraph (f)(5)(iii) of this section.
    (6) Additional guidance pertaining to pooling. The Internal Revenue 
Service may publish guidance in the Internal Revenue Bulletin (see 
Sec.  601.601(d)(2) of this chapter) prescribing additional rules for 
applying the pooling methods authorized by this section to specific 
industries or to specific types of transactions.
    (7) Example. The following example illustrates the rules of this 
paragraph (h):

    Example. Pooling. (i) In the course of its business, W 
corporation enters into 3-year non-cancelable contracts that provide 
W the right to provide services to its customers. W generally pays 
certain amounts in the process of pursuing an agreement with a 
customer, including amounts paid to credit reporting agencies to 
verify the credit history of the potential customer and commissions 
paid to the independent sales agent who secures the agreement with 
the customer. In the case of agreements that W enters into with 
customers who are individuals, the agreements contain substantially 
similar terms and conditions and W typically pays between $100 and 
$200 in the process of pursuing each transaction. During 2005, W 
enters into agreements with 300 individuals. Also during 2005, W 
enters into an agreement with X corporation containing terms and 
conditions that are substantially similar to those contained in the 
agreements W enters into with its customers who are individuals. W 
pays certain amounts in the process of pursuing the agreement with X 
that W would not typically incur in the process of pursuing an 
agreement with its customers who are individuals. For example, W 
pays amounts to prepare and submit a bid for the agreement with X 
and amounts to travel to X's headquarters to make a sales 
presentation to X's management. In the aggregate, W pays $11,000 in 
the process of obtaining the agreement with X.
    (ii) The agreements between W and its customers are agreements 
providing W the right to provide services, as described in paragraph 
(d)(6)(i)(B) of this section. Under paragraph (b)(1)(v) of this 
section, W must capitalize transaction costs paid to facilitate the 
creation of these agreements. Because W enters into at least 25 
similar transactions during 2005, W may pool its transactions for 
purposes of determining whether its transaction costs are de minimis 
within the meaning of paragraph (e)(4)(iii)(A) of this section. W 
adopts a pooling method by establishing one or more pools of similar 
transactions and by using the pooling method to compute its taxable 
income beginning in its 2005 taxable year. If W adopts a pooling 
method, W must include all similar transactions in the pool. Under 
paragraph (h)(4) of this section, the transaction with X is not 
similar to the transactions W enters into with its customers who are 
individuals. While the agreement with X contains terms and 
conditions that are substantially similar to those contained in the 
agreements W enters into with its customers who are individuals, the 
transaction costs paid in the process of pursuing the agreement with 
X are reasonably expected to differ significantly from the average 
transaction costs attributable to transactions with its customers 
who are individuals. Accordingly, W may not include the transaction 
with X in the pool of transactions with customers who are 
individuals.

    (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 (including persons to whom the taxpayer becomes 
obligated as a result of assuming a liability of that party). For this 
purpose, persons are related 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). References 
to an amount paid to or by a party include an amount paid on behalf of 
that party.
    (l) Examples. The rules of this section are illustrated by the 
following examples in which it is assumed that the Internal Revenue 
Service has not published guidance that requires capitalization under 
paragraph (b)(1)(iv) of this section (relating to amounts paid to 
create or enhance a future benefit that is identified in published 
guidance as an intangible for which capitalization is required):

    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 with 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, as provided in paragraph (f)(3) of this section, 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)(4) of this section, X is not 
required to capitalize employee compensation because such amounts 
are treated as amounts that do not facilitate the acquisition or 
creation of an intangible. 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

[[Page 457]]

creation of an intangible, 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)(4)(iii)(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 enter into an 
agreement with that party providing V the right to use tangible or 
intangible property. Accordingly, V must capitalize its $100,000 
payment to R. The franchise agreement is a self-created 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) 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, 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)(4)(iii)(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) of this section.
    Example 3. Covenant not to compete. (i) On December 1, 2005, 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 is not entered into in connection with the 
acquisition of an interest in a trade or business. The covenant not 
to compete prohibits B from competing with N for a period of 9 
months, beginning December 1, 2005. N pays B $25,000 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. N does not have a short taxable year 
in 2005 or 2006.
    (ii) Under paragraph (d)(6)(i)(C) of this section, N's payment 
of $25,000 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, 2005) or beyond the 
end of the taxable year following the taxable year in which payment 
is made, the 12-month rule contained in paragraph (f)(1) of this 
section applies. Accordingly, N is not required to capitalize its 
$25,000 payment to B or its $6,000 payment to facilitate the 
creation of the covenant not to compete.
    Example 4. 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 or create an intangible under paragraph (c) or (d) of this 
section or to facilitate such an acquisition or creation. 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 
intangibles for which capitalization is required under this section.
    Example 5. 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. V 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 or create an intangible under paragraph (c) or (d) of this 
section or to facilitate such an acquisition or creation. 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 intangibles for which 
capitalization is required under this section.
    Example 6. 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 2005, 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 or create an intangible under paragraph (c) or (d) of this 
section or to facilitate such an acquisition or creation. 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 intangibles for which capitalization 
is required under this section.
    Example 7. Product launch costs. (i) R corporation, a 
manufacturer of pharmaceutical products, is required by law to 
obtain regulatory approval before selling its products. While 
awaiting regulatory approval on Product A, R pays to develop and 
implement a marketing strategy and an advertising campaign to raise 
consumer awareness of the purported need for Product A. R also pays 
to train health care professionals and other distributors in the 
proper use of Product A.
    (ii) The amounts paid by R are not amounts paid to acquire or 
create an intangible under paragraph (c) or (d) of this section or 
to facilitate such an acquisition or creation. In addition, the 
amounts do not create a separate and distinct intangible asset 
within the meaning of paragraph (b)(3) of this section. Accordingly, 
R is not required to capitalize these amounts under this section.

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While the amounts may benefit R by creating consumer demand for 
Product A and increasing awareness of Product A among distributors, 
these benefits, without more, are not intangibles for which 
capitalization is required under this section.
    Example 8. Stocklifting costs. (i) N corporation is a wholesale 
distributor of Brand A aftermarket automobile replacement parts. In 
an effort to induce a retail automobile parts supply store to stock 
only Brand A parts, N offers to replace all of the store's inventory 
of other branded parts with Brand A parts, and to credit the store 
for its cost of other branded parts. The store is under no 
obligation to continue stocking Brand A parts or to purchase a 
minimum volume of Brand A parts from N in the future.
    (ii) The amount paid by N as a credit to the store for the cost 
of other branded parts is not an amount paid to acquire or create an 
intangible under paragraph (c) or (d) of this section or to 
facilitate such an acquisition or creation. In addition, the amount 
does not create a separate and distinct intangible asset within the 
meaning of paragraph (b)(3) of this section. Accordingly, N is not 
required to capitalize the amount under this section. While the 
amount may create a hope or expectation by N that the store will 
continue to stock Brand A parts, this benefit, without more, is not 
an intangible for which capitalization is required under this 
section.
    (iii) Alternatively, assume that N agrees to credit the store 
for its cost of other branded parts in exchange for the store's 
agreement to purchase all of its inventory requirements for such 
parts from N for a period of at least 3 years. The amount paid by N 
as a credit to the store for the cost of other branded parts is an 
amount paid to induce the store to enter into an agreement providing 
R the right to provide property. Accordingly, R must capitalize its 
payment.
    Example 9. Package design costs. (i) Z corporation manufactures 
and markets personal care products. Z pays $100,000 to a consultant 
to develop a package design for Z's newest product, Product A. Z 
also pays a fee to a government agency to obtain trademark and 
copyright protection on certain elements of the package design. Z 
pays its outside legal counsel $10,000 for services rendered in 
preparing and filing the trademark and copyright applications and 
for other services rendered in securing the trademark and copyright 
protection.
    (ii) The $100,000 paid by Z to the consultant for development of 
the package design is not an amount paid to acquire or create an 
intangible under paragraph (c) or (d) of this section or to 
facilitate such an acquisition or creation. In addition, as provided 
in paragraph (b)(3)(v) of this section, amounts paid to develop a 
package design are treated as amounts that do not create a separate 
and distinct intangible asset. Accordingly, Z is not required to 
capitalize the $100,000 payment under this section.
    (iii) The amounts paid by Z to the government agency to obtain 
trademark and copyright protection are amounts paid to a government 
agency for a right granted by that agency. Accordingly, Z must 
capitalize the payment. In addition, the $10,000 paid by Z to its 
outside counsel is an amount paid to facilitate the creation of the 
trademark and copyright. Because the aggregate amounts paid to 
facilitate the transaction exceed $5,000, the amounts are not de 
minimis as defined in paragraph (e)(4)(iii)(A) of this section. 
Accordingly, Z must capitalize the $10,000 payment to its outside 
counsel under paragraph (b)(1)(v) of this section.
    (iv) Alternatively, assume that Z acquires an existing package 
design for Product A as part of an acquisition of a trade or 
business that constitutes an applicable asset acquisition within the 
meaning of section 1060(c). Assume further that $100,000 of the 
consideration paid by N in the acquisition is properly allocable to 
the package design for Product A. Under paragraph (c)(1) of this 
section, Z must capitalize the $100,000 payment.
    Example 10. Contract to provide services. (i) Q corporation, a 
financial planning firm, provides financial advisory services on a 
fee-only basis. During 2005, Q and several other financial planning 
firms submit separate bids to R corporation for a contract to become 
one of three providers of financial advisory services to R's 
employees. Q pays $2,000 to a printing company to develop and 
produce materials for its sales presentation to R's management. Q 
also pays $6,000 to travel to R's corporate headquarters to make the 
sales presentation, and $20,000 of salaries to its employees for 
services performed in preparing the bid and making the presentation 
to R's management. Q's bid is successful and Q enters into an 
agreement with R in 2005 under which Q agrees to provide financial 
advisory services to R's employees, and R agrees to pay Q's fee on 
behalf of each employee who chooses to utilize such services. R 
enters into similar agreements with two other financial planning 
firms, and R's employees may choose to use the services of any one 
of the three firms. Based on its past experience, Q reasonably 
expects to provide services to at least 5 percent of R's employees.
    (ii) Q's agreement with R is not an agreement providing Q the 
right to provide services, as described in paragraph (d)(6)(i)(B) of 
this section. Under paragraph (d)(6)(iv) the agreement places no 
obligation on another person to request or pay for Q's services. 
Accordingly, Q is not required to capitalize any of the amounts paid 
in the process of pursuing the agreement with R.
    Example 11. Mutual fund distributor. (i) D incurs costs to enter 
into a distribution agreement with M, a mutual fund. The initial 
term of the distribution agreement is two years, and afterwards must 
be approved annually by M. The distribution agreement can be 
terminated by either party on 60 days notice. Although distribution 
agreements are rarely terminated in the mutual fund industry, M is 
not economically compelled to continue D's distribution agreement. 
Under the distribution agreement, D has the exclusive right to sell 
shares of M and agrees to use its best efforts to solicit orders for 
the sale of shares of M. D sells shares in M directly to the general 
public as well as through brokers. When an investor places an order 
for M shares with a broker, D pays the broker a commission for 
selling the shares to the investor. Under the distribution 
agreement, D receives compensation from M in the form of 12b-1 fees 
(which equal a percentage of M's net asset value attributable to 
investors that have held their shares for up to 6 years) and 
contingent deferred sales charges (which are paid if the investor 
redeems the purchased shares within 6 years).
    (ii) The distribution agreement is not an agreement providing D 
with the right to provide services, as described in paragraph 
(d)(6)(i)(B) of this section, because the distribution agreement can 
be terminated by M at will upon 60 days notice and M is not 
economically compelled to continue the distribution agreement. 
Accordingly, D is not required to capitalize the costs of creating 
(or facilitating the creation of) the distribution agreement under 
paragraphs (b)(1)(ii) or (v) of this section. In addition, as 
provided in paragraph (b)(3)(ii) of this section, amounts paid to 
create an agreement are treated as amounts that do not create a 
separate and distinct intangible asset. Accordingly, D also is not 
required to capitalize the costs of creating (or facilitating the 
creation of) the distribution agreement under paragraph (b)(1)(iii) 
or (v) of this section.
    (iii) Under paragraph (b)(3)(iii), the broker commissions paid 
by D in performing services under the distribution agreement do not 
create (or facilitate the creation of) a separate and distinct 
intangible asset. In addition, the broker commissions do not create 
an intangible described in paragraph (d) of this section. 
Accordingly, D is not required to capitalize the broker commissions 
under this section.

    (m) Amortization. For rules relating to amortization of certain 
intangibles, see Sec.  1.167(a)-3.
    (n) Intangible interests in land. [Reserved].
    (o) Effective date. This section applies to amounts paid or 
incurred on or after December 31, 2003.
    (p) Accounting method changes--(1) In general. A taxpayer seeking 
to change a method of accounting to comply with this section must 
secure the consent of the Commissioner in accordance with the 
requirements of Sec.  1.446-1(e). For the taxpayer's first taxable year 
ending on or after December 31, 2003, the taxpayer is granted the 
consent of the Commissioner to change its method of accounting to 
comply with this section, provided the taxpayer follows the 
administrative procedures issued under Sec.  1.446-1(e)(3)(ii) for 
obtaining the Commissioner's automatic consent to a change in 
accounting method (for further guidance, for example, see Rev. Proc. 
2002-9 (2002-1 C.B. 327) and Sec.  601.601(d)(2)(ii)(b) of this 
chapter).
    (2) Scope limitations. Any limitations on obtaining the automatic 
consent of the Commissioner do not apply to a taxpayer seeking to 
change to a method of accounting to comply with this section for its 
first taxable year ending on or after December 31, 2003.

[[Page 459]]

    (3) Section 481(a) adjustment. With the exception of a change to a 
pooling method authorized by this section, the section 481(a) 
adjustment for a change in method of accounting to comply with this 
section for a taxpayer's first taxable year ending on or after December 
31, 2003 is determined by taking into account only amounts paid or 
incurred in taxable years ending on or after January 24, 2002. A 
taxpayer seeking to change to a pooling method authorized by this 
section on or after the effective date of these regulations must change 
to the method using a cut-off method.


Sec.  1.263(a)-5  Amounts paid or incurred to facilitate an acquisition 
of a trade or business, a change in the capital structure of a business 
entity, and certain other transactions.

    (a) General rule. A taxpayer must capitalize an amount paid to 
facilitate (within the meaning of paragraph (b) of this section) each 
of the following transactions, without regard to whether the 
transaction is comprised of a single step or a series of steps carried 
out as part of a single plan and without regard to whether gain or loss 
is recognized in the transaction:
    (1) An acquisition of assets that constitute a trade or business 
(whether the taxpayer is the acquirer in the acquisition or the target 
of the acquisition).
    (2) An acquisition by the taxpayer of an ownership interest in a 
business entity if, immediately after the acquisition, the taxpayer and 
the business entity are related within the meaning of section 267(b) or 
707(b) (see Sec.  1.263(a)-4 for rules requiring capitalization of 
amounts paid by the taxpayer to acquire an ownership interest in a 
business entity, or to facilitate the acquisition of an ownership 
interest in a business entity, where the taxpayer and the business 
entity are not related within the meaning of section 267(b) or 707(b) 
immediately after the acquisition).
    (3) An acquisition of an ownership interest in the taxpayer (other 
than an acquisition by the taxpayer of an ownership interest in the 
taxpayer, whether by redemption or otherwise).
    (4) A restructuring, recapitalization, or reorganization of the 
capital structure of a business entity (including reorganizations 
described in section 368 and distributions of stock by the taxpayer as 
described in section 355).
    (5) A transfer described in section 351 or section 721 (whether the 
taxpayer is the transferor or transferee).
    (6) A formation or organization of a disregarded entity.
    (7) An acquisition of capital.
    (8) A stock issuance.
    (9) A borrowing. For purposes of this section, a borrowing means 
any issuance of debt, including an issuance of debt in an acquisition 
of capital or in a recapitalization. A borrowing also includes debt 
issued in a debt for debt exchange under Sec.  1.1001-3.
    (10) Writing an option.
    (b) Scope of facilitate--(1) In general. Except as otherwise 
provided in this section, an amount is paid to facilitate a transaction 
described in paragraph (a) of this section if the amount is paid in the 
process of investigating or otherwise pursuing the transaction. Whether 
an amount is paid in the process of investigating or otherwise pursuing 
the transaction is determined based on all of the facts and 
circumstances. In determining whether an amount is paid to facilitate a 
transaction, the fact that the amount would (or would not) have been 
paid but for the transaction is relevant, but is not determinative. An 
amount paid to determine the value or price of a transaction is an 
amount paid in the process of investigating or otherwise pursuing the 
transaction. An amount paid to another party in exchange for tangible 
or intangible property is not an amount paid to facilitate the 
exchange. For example, the purchase price paid to the target of an 
asset acquisition in exchange for its assets is not an amount paid to 
facilitate the acquisition. Similarly, the purchase price paid by an 
acquirer to the target's shareholders in exchange for their stock in a 
stock acquisition is not an amount paid to facilitate the acquisition 
of the stock. See Sec.  1.263(a)-1, Sec.  1.263(a)-2, and Sec.  
1.263(a)-4 for rules requiring capitalization of the purchase price 
paid to acquire property.
    (2) Ordering rules. An amount paid in the process of investigating 
or otherwise pursuing both a transaction described in paragraph (a) of 
this section and an acquisition or creation of an intangible described 
in Sec.  1.263(a)-4 is subject to the rules contained in this section, 
and not to the rules contained in Sec.  1.263(a)-4. In addition, an 
amount required to be capitalized by Sec.  1.263(a)-1, Sec.  1.263(a)-
2, or Sec.  1.263(a)-4 does not facilitate a transaction described in 
paragraph (a) of this section.
    (c) Special rules for certain costs--(1) Borrowing costs. An amount 
paid to facilitate a borrowing does not facilitate another transaction 
(other than the borrowing) described in paragraph (a) of this section.
    (2) Costs of asset sales. An amount paid by a taxpayer to 
facilitate a sale of its assets does not facilitate another transaction 
(other than the sale) described in paragraph (a) of this section. For 
example, where a target corporation, in preparation for a merger with 
an acquiring corporation, sells assets that are not desired by the 
acquiring corporation, amounts paid to facilitate the sale of the 
unwanted assets are not required to be capitalized as amounts paid to 
facilitate the merger.
    (3) Mandatory stock distributions. An amount paid in the process of 
investigating or otherwise pursuing a distribution of stock by a 
taxpayer to its shareholders does not facilitate a transaction 
described in paragraph (a) of this section if the divestiture of the 
stock (or of properties transferred to an entity whose stock is 
distributed) is required by law, regulatory mandate, or court order. A 
taxpayer is not required to capitalize (under this section or Sec.  
1.263(a)-4) an amount paid to organize (or facilitate the organization 
of) an entity if the entity is organized solely to receive properties 
that the taxpayer is required to divest by law, regulatory mandate, or 
court order and if the taxpayer distributes the stock of the entity to 
its shareholders. A taxpayer also is not required to capitalize (under 
this section or Sec.  1.263(a)-4) an amount paid to transfer property 
to an entity if the taxpayer is required to divest itself of that 
property by law, regulatory mandate, or court order and if the stock of 
the recipient entity is distributed to the taxpayer's shareholders.
    (4) Bankruptcy reorganization costs. An amount paid to institute or 
administer a proceeding under Chapter 11 of the Bankruptcy Code by a 
taxpayer that is the debtor under the proceeding constitutes an amount 
paid to facilitate a reorganization within the meaning of paragraph 
(a)(4) of this section, regardless of the purpose for which the 
proceeding is instituted. For example, an amount paid to prepare and 
file a petition under Chapter 11, to obtain an extension of the 
exclusivity period under Chapter 11, to formulate plans of 
reorganization under Chapter 11, to analyze plans of reorganization 
formulated by another party in interest, or to contest or obtain 
approval of a plan of reorganization under Chapter 11 facilitates a 
reorganization within the meaning of this section. However, amounts 
specifically paid to formulate, analyze, contest or obtain approval of 
the portion of a plan of reorganization under Chapter 11 that resolves 
tort liabilities of the taxpayer do not facilitate a reorganization 
within the meaning of paragraph (a)(4) of this section if the amounts 
would have been treated as ordinary and necessary business expenses 
under section 162 had the bankruptcy proceeding not been instituted. In 
addition, an amount paid

[[Page 460]]

by the taxpayer to defend against the commencement of an involuntary 
bankruptcy proceeding against the taxpayer does not facilitate a 
reorganization within the meaning of paragraph (a)(4) of this section. 
An amount paid by the debtor to operate its business during a Chapter 
11 bankruptcy proceeding is not an amount paid to institute or 
administer the bankruptcy proceeding and does not facilitate a 
reorganization. Such amount is treated in the same manner as it would 
have been treated had the bankruptcy proceeding not been instituted.
    (5) 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 
described in paragraph (a) of this section unless the amounts are paid 
during the initial stock offering period.
    (6) Integration costs. An amount paid to integrate the business 
operations of the taxpayer with the business operations of another does 
not facilitate a transaction described in paragraph (a) of this 
section, regardless of when the integration activities occur.
    (7) Registrar and transfer agent fees for the maintenance of 
capital stock records. An amount paid by a taxpayer to a registrar or 
transfer agent in connection with the transfer of the taxpayer's 
capital stock does not facilitate a transaction described in paragraph 
(a) of this section unless the amount is paid with respect to a 
specific transaction described in paragraph (a). For example, a 
taxpayer is not required to capitalize periodic payments to a transfer 
agent for maintaining records of the names and addresses of 
shareholders who trade the taxpayer's shares on a national exchange. By 
comparison, a taxpayer is required to capitalize an amount paid to the 
transfer agent for distributing proxy statements requesting shareholder 
approval of a transaction described in paragraph (a) of this section.
    (8) Termination payments and amounts paid to facilitate mutually 
exclusive transactions. An amount paid to terminate (or facilitate the 
termination of) an agreement to enter into a transaction described in 
paragraph (a) of this section constitutes an amount paid to facilitate 
a second transaction described in paragraph (a) of this section only if 
the transactions are mutually exclusive. An amount paid to facilitate a 
transaction described in paragraph (a) of this section is treated as an 
amount paid to facilitate a second transaction described in paragraph 
(a) of this section only if the transactions are mutually exclusive.
    (d) Simplifying conventions--(1) In general. For purposes of this 
section, employee compensation (within the meaning of paragraph (d)(2) 
of this section), overhead, and de minimis costs (within the meaning of 
paragraph (d)(3) of this section) are treated as amounts that do not 
facilitate a transaction described in paragraph (a) of this section.
    (2) Employee compensation--(i) In general. The term employee 
compensation means compensation (including salary, bonuses and 
commissions) paid to an employee of the taxpayer. 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) Certain amounts treated as employee compensation. For purposes 
of this section, a guaranteed payment to a partner in a partnership is 
treated as employee compensation. For purposes of this section, annual 
compensation paid to a director of a corporation is treated as employee 
compensation. For example, an amount paid to a director of a 
corporation for attendance at a regular meeting of the board of 
directors (or committee thereof) is treated as employee compensation 
for purposes of this section. However, an amount paid to the director 
for attendance at a special meeting of the board of directors (or 
committee thereof) is not treated as employee compensation. An amount 
paid to a person that is not an employee of the taxpayer (including the 
employer of the individual who performs the services) is treated as 
employee compensation for purposes of this section only if the amount 
is paid for secretarial, clerical, or similar administrative support 
services (other than services involving the preparation and 
distribution of proxy solicitations and other documents seeking 
shareholder approval of a transaction described in paragraph (a) of 
this section). In the case of an affiliated group of corporations 
filing a consolidated federal income tax return, a payment by one 
member of the group to a second member of the group for services 
performed by an employee of the second member is treated as employee 
compensation if the services provided by the employee are provided at a 
time during which both members are affiliated.
    (3) De minimis costs--(i) In general. The term de minimis costs 
means amounts (other than employee compensation and overhead) paid in 
the process of investigating or otherwise pursuing a transaction 
described in paragraph (a) of this section if, in the aggregate, the 
amounts do not exceed $5,000 (or such greater amount as may be set 
forth in published guidance). If the amounts exceed $5,000 (or such 
greater amount as may be set forth in published guidance), none of the 
amounts are de minimis costs within the meaning of this paragraph 
(d)(3). For purposes of this paragraph (d)(3), an amount paid in the 
form of property is valued at its fair market value at the time of the 
payment.
    (ii) Treatment of commissions. The term de minimis costs does not 
include commissions paid to facilitate a transaction described in 
paragraph (a) of this section.
    (4) Election to capitalize. A taxpayer may elect to treat employee 
compensation, overhead, or de minimis costs paid in the process of 
investigating or otherwise pursuing a transaction described in 
paragraph (a) of this section as amounts that facilitate the 
transaction. The election is made separately for each transaction and 
applies to employee compensation, overhead, or de minimis costs, or to 
any combination thereof. For example, a taxpayer may elect to treat 
overhead and de minimis costs, but not employee compensation, as 
amounts that facilitate the transaction. A taxpayer makes the election 
by treating the amounts to which the election applies as amounts that 
facilitate the transaction in the taxpayer's timely filed original 
federal income tax return (including extensions) for the taxable year 
during which the amounts are paid. In the case of an affiliated group 
of corporations filing a consolidated return, the election is made 
separately with respect to each member of the group, and not with 
respect to the group as a whole. In the case of an S corporation or 
partnership, the election is made by the S corporation or by the 
partnership, and not by the shareholders or partners. An election made 
under this paragraph (d)(4) is revocable with respect to each taxable 
year for which made only with the consent of the Commissioner.
    (e) Certain acquisitive transactions--(1) In general. Except as 
provided in paragraph (e)(2) of this section (relating to inherently 
facilitative amounts), an amount paid by the taxpayer in the process of 
investigating or otherwise pursuing a covered transaction (as described 
in paragraph (e)(3) of this section) facilitates the transaction within 
the meaning of this section only if the amount relates to activities 
performed on or after the earlier of--

[[Page 461]]

    (i) The date on which a letter of intent, exclusivity agreement, or 
similar written communication (other than a confidentiality agreement) 
is executed by representatives of the acquirer and the target; or
    (ii) The date on which the material terms of the transaction (as 
tentatively agreed to by representatives of the acquirer and the 
target) are authorized or 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 material terms of the 
transaction (as tentatively agreed to by representatives of the 
acquirer and the target) are authorized or approved by the appropriate 
governing officials of the taxpayer. In the case of a transaction that 
does not require authorization or approval of the taxpayer's board of 
directors (or appropriate governing officials in the case of a taxpayer 
that is not a corporation) the date determined under this paragraph 
(e)(1)(ii) is the date on which the acquirer and the target execute a 
binding written contract reflecting the terms of the transaction.
    (2) Exception for inherently facilitative amounts. An amount paid 
in the process of investigating or otherwise pursuing a covered 
transaction facilitates that transaction if the amount is inherently 
facilitative, regardless of whether the amount is paid for activities 
performed prior to the date determined under paragraph (e)(1) of this 
section. An amount is inherently facilitative if the amount is paid 
for--
    (i) Securing an appraisal, formal written evaluation, or fairness 
opinion related to the transaction;
    (ii) Structuring the transaction, including negotiating the 
structure of the transaction and obtaining tax advice on the structure 
of the transaction (for example, obtaining tax advice on the 
application of section 368);
    (iii) Preparing and reviewing the documents that effectuate the 
transaction (for example, a merger agreement or purchase agreement);
    (iv) Obtaining regulatory approval of the transaction, including 
preparing and reviewing regulatory filings;
    (v) Obtaining shareholder approval of the transaction (for example, 
proxy costs, solicitation costs, and costs to promote the transaction 
to shareholders); or
    (vi) Conveying property between the parties to the transaction (for 
example, transfer taxes and title registration costs).
    (3) Covered transactions. For purposes of this paragraph (e), the 
term covered transaction means the following transactions:
    (i) A taxable acquisition by the taxpayer of assets that constitute 
a trade or business.
    (ii) A taxable acquisition of an ownership interest in a business 
entity (whether the taxpayer is the acquirer in the acquisition or the 
target of the acquisition) if, immediately after the acquisition, the 
acquirer and the target are related within the meaning of section 
267(b) or 707(b).
    (iii) A reorganization described in section 368(a)(1)(A), (B), or 
(C) or a reorganization described in section 368(a)(1)(D) in which 
stock or securities of the corporation to which the assets are 
transferred are distributed in a transaction which qualifies under 
section 354 or 356 (whether the taxpayer is the acquirer or the target 
in the reorganization).
    (f) Documentation of success-based fees--An amount paid that is 
contingent on the successful closing of a transaction described in 
paragraph (a) of this section is an amount paid to facilitate the 
transaction except to the extent the taxpayer maintains sufficient 
documentation to establish that a portion of the fee is allocable to 
activities that do not facilitate the transaction. This documentation 
must be completed on or before the due date of the taxpayer's timely 
filed original federal income tax return (including extensions) for the 
taxable year during which the transaction closes. For purposes of this 
paragraph (f), documentation must consist of more than merely an 
allocation between activities that facilitate the transaction and 
activities that do not facilitate the transaction, and must consist of 
supporting records (for example, time records, itemized invoices, or 
other records) that identify--
    (1) The various activities performed by the service provider;
    (2) The amount of the fee (or percentage of time) that is allocable 
to each of the various activities performed;
    (3) Where the date the activity was performed is relevant to 
understanding whether the activity facilitated the transaction, the 
amount of the fee (or percentage of time) that is allocable to the 
performance of that activity before and after the relevant date; and
    (4) The name, business address, and business telephone number of 
the service provider.
    (g) Treatment of capitalized costs--(1) Tax-free acquisitive 
transactions. [Reserved]
    (2) Taxable acquisitive transactions--(i) Acquirer. In the case of 
an acquisition, merger, or consolidation that is not described in 
section 368, an amount required to be capitalized under this section by 
the acquirer is added to the basis of the acquired assets (in the case 
of a transaction that is treated as an acquisition of the assets of the 
target for federal income tax purposes) or the acquired stock (in the 
case of a transaction that is treated as an acquisition of the stock of 
the target for federal income tax purposes).
    (ii) Target--(A) Asset acquisition. In the case of an acquisition, 
merger, or consolidation that is not described in section 368 and that 
is treated as an acquisition of the assets of the target for federal 
income tax purposes, an amount required to be capitalized under this 
section by the target is treated as a reduction of the target's amount 
realized on the disposition of its assets.
    (B) Stock acquisition. [Reserved]
    (3) Stock issuance transactions. [Reserved]
    (4) Borrowings. For the treatment of amounts required to be 
capitalized under this section with respect to a borrowing, see Sec.  
1.446-5.
    (5) Treatment of capitalized amounts by option writer. An amount 
required to be capitalized by an option writer under paragraph (a)(10) 
of this section is not currently deductible under section 162 or 212. 
Instead, the amount required to be capitalized generally reduces the 
total premium received by the option writer. However, other provisions 
of law may limit the reduction of the premium by the capitalized amount 
(for example, if the capitalized amount is never deductible by the 
option writer).
    (h) 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.
    (i) [Reserved]
    (j) Coordination with other provisions of the Internal Revenue 
Code. Nothing in this section changes the treatment of an amount that 
is specifically provided for under any other provision of the Internal 
Revenue Code (other than section 162(a) or 212) or regulations 
thereunder.
    (k) Treatment of indirect payments. For purposes of this section, 
references to an amount paid to or by a party include an amount paid on 
behalf of that party.
    (l) Examples. The following examples illustrate the rules of this 
section:

    Example 1. 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

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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 (a)(8) of this section (whether 
incurred before or after the issuance of the stock and whether or 
not the registration is productive of equity capital).
    Example 2. 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 (a)(9) of this section. As provided in paragraph 
(c)(1) 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. See Sec.  1.446-5 for the 
treatment of Q's capitalized payment.
    Example 3. Costs to facilitate. (i) Z agrees to pay investment 
banker B $1,000,000 for B's services in evaluating four alternative 
transactions ($250,000 for each alternative): An initial public 
offering; a borrowing of funds; an acquisition by Z of a competitor; 
and an acquisition of Z by a competitor. Z eventually decides to 
pursue a borrowing and abandons the other options.
    (ii) The $250,000 payment to evaluate the possibility of a 
borrowing is an amount paid in the process of investigating or 
otherwise pursuing a transaction described in paragraph (a)(9) of 
this section. Accordingly Z must capitalize that $250,000 payment to 
B. See Sec.  1.446-5 for the treatment of Z's capitalized payment.
    (iii) The $250,000 payment to evaluate the possibility of an 
initial public offering is an amount paid in the process of 
investigating or otherwise pursuing a transaction described in 
paragraph (a)(8) of this section. Accordingly, Z must capitalize 
that $250,000 payment to B under this section. Because the borrowing 
and the initial public offering are not mutually exclusive 
transactions, the $250,000 is not treated as an amount paid to 
facilitate the borrowing. When Z abandons the initial public 
offering, Z may recover under section 165 the $250,000 paid to 
facilitate the initial public offering.
    (iv) The $500,000 paid by Z to evaluate the possibilities of an 
acquisition of Z by a competitor and an acquisition of a competitor 
by Z are amounts paid in the process of investigating or otherwise 
pursuing transactions described in paragraphs (a) and (e)(3) of this 
section. Accordingly, Z is only required to capitalize under this 
section the portion of the $500,000 payment that relates to 
inherently facilitative activities under paragraph (e)(2) of this 
section or to activities performed on or after the date determined 
under paragraph (e)(1) of this section. Because the borrowing and 
the possible acquisitions are not mutually exclusive transactions, 
no portion of the $500,000 is treated as an amount paid to 
facilitate the borrowing. When Z abandons the acquisition 
transactions, Z may recover under section 165 any portion of the 
$500,000 that was paid to facilitate the acquisitions.
    Example 4. Corporate acquisition. (i) On February 1, 2005, 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 
and has the financial ability to consummate. On March 1, 2005, R 
enters into an exclusivity agreement with T and stops pursuing U and 
V. On July 1, 2005, R acquires all of 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 T, U, and V; 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)(1) of this section, the amounts paid to 
conduct due diligence on T, U and V prior to March 1, 2005 (the date 
of the exclusivity agreement) are not amounts paid to facilitate the 
acquisition of the stock of T, U or V and are not required to be 
capitalized under this section. However, the amounts paid to conduct 
due diligence on T on and after March 1, 2005, are amounts paid to 
facilitate the acquisition of the stock of T and must be capitalized 
under paragraph (a)(2) of this section.
    (iii) Under paragraph (e)(2) 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, on, or after March 1, 2005.
    (iv) Under paragraph (e)(2) 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. Because the acquisition of U, V, and T are not mutually 
exclusive transactions, the costs that facilitate the acquisition of 
U and V do not facilitate the acquisition of T. Accordingly, the 
amounts paid to determine the value of U and V may be recovered 
under section 165 in the taxable year that R abandons the planned 
mergers with U and V.
    Example 5. Corporate acquisition; employee bonus. Assume the 
same facts as in Example 4, except R pays a bonus of $10,000 to one 
of its corporate officers who negotiated the acquisition of T. As 
provided by paragraph (d)(1) of this section, Y is not required to 
capitalize any portion of the bonus paid to the corporate officer.
    Example 6. Corporate acquisition; integration costs. Assume the 
same facts as in Example 4, 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 (c)(6) 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 7. Corporate acquisition; compensation to target's 
employees. Assume the same facts as in Example 4, except that, prior 
to the acquisition, certain employees of T held unexercised options 
issued pursuant to T's 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 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 (d)(1) of this section, T 
is not required to capitalize the amounts paid to its employees. See 
section 83 for the treatment of amounts received in cancellation of 
stock options.
    Example 8. Asset acquisition; employee compensation. N 
corporation owns tangible and intangible assets that constitute a 
trade or business. M corporation purchases all the assets of N in a 
taxable transaction. Under paragraph (a)(1) of this section, M must 
capitalize amounts paid to facilitate the acquisition of the assets 
of N. Under paragraph (d)(1) of this section, no portion of the 
salaries of M's employees who work on the acquisition are treated as 
facilitating the transaction.
    Example 9. 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 acquisition of 
an ownership interest in Y as described in paragraph (a)(3) of this 
section. Y must capitalize the full amount of the $60,000 legal fee.
    Example 10. Corporate acquisition; antitrust defense costs. On 
March 1, 2005, V corporation enters into an agreement with X 
corporation to acquire all of the outstanding stock of X. On April 
1, 2005, 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, 2005, 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, 2005. 
After June 1, 2005, the regulators pursue antitrust litigation 
against V seeking

[[Page 463]]

rescission of the acquisition. V pays $50,000 to its outside counsel 
for services rendered after June 1, 2005, 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 
(a)(2) 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. V must capitalize the $50,000 in legal fees.
    Example 11. Corporate acquisition; defensive measures. (i) On 
January 15, 2005, Y corporation, a publicly traded corporation, 
becomes the target of a hostile takeover attempt by Z corporation. 
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. Y also pays amounts 
to complete a defensive recapitalization, and pays $50,000 to an 
investment banker for a fairness opinion regarding Z's initial 
offer. Y's efforts to enjoin the takeover and locate a white knight 
acquirer are unsuccessful, and on March 15, 2005, 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 an investment banker $1,000,000 for a second 
fairness opinion and for services rendered in negotiating with Z.
    (ii) The legal fees paid by Y to seek an injunction against the 
takeover are not amounts paid in the process of investigating or 
otherwise pursuing the transaction with Z. Accordingly, these legal 
fees are not required to be capitalized under this section.
    (iii) The investment banking fees paid to search for a white 
knight acquirer do not facilitate an acquisition of Y by a white 
knight because none of Y's costs with respect to a white knight were 
inherently facilitative amounts and because Y did not reach the date 
described in paragraph (e)(1) of this section with respect to a 
white knight. Accordingly, these amounts are not required to be 
capitalized under this section.
    (iv) The amounts paid by Y to investigate and complete the 
recapitalization must be capitalized under paragraph (a)(4) of this 
section.
    (v) The $50,000 paid to the investment bankers for a fairness 
opinion during Y's defense against the takeover and the $1,000,000 
paid to the investment bankers after Y abandons its defense against 
the takeover are inherently facilitative amounts with respect to the 
transaction with Z and must be capitalized under paragraph (a)(3) of 
this section.
    Example 12. Corporate acquisition; acquisition by white knight. 
(i) Assume the same facts as in Example 11, except that Y's 
investment bankers identify three potential white knight acquirers: 
U corporation, V corporation, and W corporation. Y pays its 
investment bankers to conduct due diligence on the three potential 
white knight acquirers. On March 15, 2005, Y's board of directors 
approves a tentative acquisition agreement under which W agrees to 
acquire all of the stock of Y, and the investment bankers stop due 
diligence on U and V. On June 15, 2005, W acquires all of the stock 
of Y.
    (ii) Under paragraph (e)(1) of this section, the amounts paid to 
conduct due diligence on U, V, and W prior to March 15, 2005 (the 
date of board of directors' approval) are not amounts paid to 
facilitate the acquisition of the stock of Y and are not required to 
be capitalized under this section. However, the amounts paid to 
conduct due diligence on W on and after March 15, 2005, facilitate 
the acquisition of the stock of Y and are required to be 
capitalized.
    EXAMPLE 13. Corporate acquisition; mutually exclusive costs. (i) 
Assume the same facts as in Example 11, except that Y's investment 
banker finds W, a white knight. Y and W execute a letter of intent 
on March 10, 2005. Under the terms of the letter of intent, Y must 
pay W a $10,000,000 break-up fee if the merger with W does not 
occur. On April 1, 2005, Z significantly increases the amount of its 
offer, and Y decides to accept Z's offer instead of merging with W. 
Y pays its investment banker $500,000 for inherently facilitative 
costs with respect to the potential merger with W. Y also pays its 
investment banker $2,000,000 for due diligence costs with respect to 
the potential merger with W, $1,000,000 of which relates to services 
performed on or after March 10, 2005.
    (ii) Y's $500,000 payment for inherently facilitative costs and 
Y's $1,000,000 payment for due diligence activities performed on or 
after March 10, 2005 (the date the letter of intent with W is 
entered into) facilitate the potential merger with W. Because Y 
could not merge with both W and Z, under paragraph (c)(8) of this 
section the $500,000 and $1,000,000 payments also facilitate the 
transaction between Y and Z. Accordingly, Y must capitalize the 
$500,000 and $1,000,000 payments as amounts that facilitate the 
transaction with Z.
    (iii) Similarly, because Y could not merge with both W and Z, 
under paragraph (c)(8) of this section the $10,000,000 termination 
payment facilitates the transaction between Y and Z. Accordingly, Y 
must capitalize the $10,000,000 termination payment as an amount 
that facilitates the transaction with Z.
    Example 14. Break-up fee; transactions not mutually exclusive. N 
corporation and U corporation enter into an agreement under which U 
would acquire all the stock or all the assets of N in exchange for U 
stock. Under the terms of the agreement, if either party terminates 
the agreement, the terminating party must pay the other party 
$10,000,000. U decides to terminate the agreement and pays N 
$10,000,000. Shortly thereafter, U acquires all the stock of V 
corporation, a competitor of N. U had the financial resources to 
have acquired both N and V. U's $10,000,000 payment does not 
facilitate U's acquisition of V. Accordingly, U is not required to 
capitalize the $10,000,000 payment under this section.
    Example 15. Corporate reorganization; initial public offering. Y 
corporation is a closely held corporation. Y's board of directors 
authorizes an initial public offering of Y's stock 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. The 
investment banking and legal services are performed both before and 
after board authorization. Under paragraph (a)(8) of this section, 
the $5,000,000 is an amount paid to facilitate a stock issuance.
    Example 16. Auction. (i) N corporation seeks to dispose of all 
of the stock of its wholly owned subsidiary, P corporation, through 
an auction process and requests that each bidder submit a non-
binding purchase offer in the form of a draft agreement. Q 
corporation hires an investment banker to assist in the preparation 
of Q's bid to acquire P and to conduct a due diligence investigation 
of P. On July 1, 2005, Q submits its draft agreement. On August 1, 
2005, N informs Q that it has accepted Q's offer, and presents Q 
with a signed letter of intent to sell all of the stock of P to Q. 
On August 5, 2005, Q's board of directors approves the terms of the 
transaction and authorizes Q to execute the letter of intent. Q 
executes a binding letter of intent with N on August 6, 2005.
    (ii) Under paragraph (e)(1) of this section, the amounts paid by 
Q to its investment banker that are not inherently facilitative and 
that are paid for activities performed prior to August 5, 2005 (the 
date Q's board of directors approves the transaction) are not 
amounts paid to facilitate the acquisition of P. Amounts paid by Q 
to its investment banker for activities performed on or after August 
5, 2005, and amounts paid by Q to its investment banker that are 
inherently facilitative amounts within the meaning of paragraph 
(e)(2) of this section are required to be capitalized under this 
section.
    Example 17. Stock distribution. Z corporation distributes 
natural gas throughout state Y. The federal government brings an 
antitrust action against Z seeking divestiture of certain of Z's 
natural gas distribution assets. As a result of a court ordered 
divestiture, Z and the federal government agree to a plan of 
divestiture that requires Z to organize a subsidiary to receive the 
divested assets and to distribute the stock of the subsidiary to its 
shareholders. During 2005, Z pays $300,000 to various independent 
contractors for the following services: studying customer demand in 
the area to be served by the divested assets, identifying assets to 
be transferred to the subsidiary, organizing the subsidiary, 
structuring the transfer of assets to the subsidiary to qualify as a 
tax-free transaction to Z, and distributing the stock of the 
subsidiary to the stockholders. Under paragraph (c)(3) of this 
section, Z is not required to capitalize any portion of the $300,000 
payments.
    Example 18. Bankruptcy reorganization. (i) X corporation is the 
defendant in numerous lawsuits alleging tort liability based on X's 
role in manufacturing certain defective products. X files a petition 
for reorganization under Chapter 11 of the Bankruptcy Code in

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an effort to manage all of the lawsuits in a single proceeding. X 
pays its outside counsel to prepare the petition and plan of 
reorganization, to analyze adequate protection under the plan, to 
attend hearings before the Bankruptcy Court concerning the plan, and 
to defend against motions by creditors and tort claimants to strike 
the taxpayer's plan.
    (ii) X's reorganization under Chapter 11 of the Bankruptcy Code 
is a reorganization within the meaning of paragraph (a)(4) of this 
section. Under paragraph (c)(4) of this section, amounts paid by X 
to its outside counsel to prepare, analyze or obtain approval of the 
portion of X's plan of reorganization that resolves X's tort 
liability do not facilitate the reorganization and are not required 
to be capitalized, provided that such amounts would have been 
treated as ordinary and necessary business expenses under section 
162 had the bankruptcy proceeding not been instituted. All other 
amounts paid by X to its outside counsel for the services described 
above (including all amounts paid to prepare the bankruptcy 
petition) facilitate the reorganization and must be capitalized.

    (m) Effective date. This section applies to amounts paid or 
incurred on or after December 31, 2003.
    (n) Accounting method changes--(1) In general. A taxpayer seeking 
to change a method of accounting to comply with this section must 
secure the consent of the Commissioner in accordance with the 
requirements of Sec.  1.446-1(e). For the taxpayer's first taxable year 
ending on or after December 31, 2003, the taxpayer is granted the 
consent of the Commissioner to change its method of accounting to 
comply with this section, provided the taxpayer follows the 
administrative procedures issued under Sec.  1.446-1(e)(3)(ii) for 
obtaining the Commissioner's automatic consent to a change in 
accounting method (for further guidance, for example, see Rev. Proc. 
2002-9 (2002-1 C.B. 327) and Sec.  601.601(d)(2)(ii)(b) of this 
chapter).
    (2) Scope limitations. Any limitations on obtaining the automatic 
consent of the Commissioner do not apply to a taxpayer seeking to 
change to a method of accounting to comply with this section for its 
first taxable year ending on or after December 31, 2003.
    (3) Section 481(a) adjustment. The section 481(a) adjustment for a 
change in method of accounting to comply with this section for a 
taxpayer's first taxable year ending on or after December 31, 2003 is 
determined by taking into account only amounts paid or incurred in 
taxable years ending on or after January 24, 2002.
0
Par. 5. 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)-5. 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 determine issue price. Thus, debt issuance costs increase 
or create original issue 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) Examples. The following examples illustrate the rules of this 
section:

    Example 1. (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 the de minimis amount of original issue discount for 
the loan determined under Sec.  1.1273-1(d) ($125,000 ($10,000,000 x 
.0025 x 5)), 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.
    Example 2. (i) Assume the same facts as in Example 1, except 
that X incurs debt issuance costs of $120,000 rather than $130,000.
    (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 $120,000, 
resulting in an issue price of $9,880,000. As a result, X treats the 
loan as having original issue discount in the amount of $120,000 
(stated redemption price at maturity of $10,000,000 minus the issue 
price of $9,880,000). Because this amount of original issue discount 
is less than the de minimis amount of original issue discount for 
the loan determined under Sec.  1.1273-1(d) ($125,000), X does not 
have to use the constant yield method described in Sec.  1.1272-1(b) 
to allocate the original issue discount to each year. Instead, under 
Sec.  1.163-7(b)(2), X can choose to allocate the original issue 
discount to each year on a straight-line basis over the term of the 
loan or in proportion to the stated interest payments ($24,000 each 
year). X also could choose to deduct the original issue discount at 
maturity of the loan. X makes its choice by reporting the original 
issue discount in a manner consistent with the method chosen on X's 
timely filed federal income tax return for 2004. If X wanted to use 
the constant yield method, based on a yield of 5.279%, compounded 
annually, the original issue discount is allocable to each year as 
follows: $21,596 for 2004, $22,736 for 2005, $23,937 for 2006, 
$25,200 for 2007, and $26,531 for 2008.

    (d) Effective date. This section applies to debt issuance costs 
paid or incurred for debt instruments issued on or after December 31, 
2003.
    (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 December 31, 2003. 
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

[[Page 465]]

    (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.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

0
Par. 6. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.

0
Par. 7. In Sec.  602.101, paragraph (b) is amended by adding an entry 
in numerical order for Sec.  1.263(a)-5 to read as follows:


Sec.  602.101  OMB Control numbers.

* * * * *
    (b) * * *

------------------------------------------------------------------------
                                                            Current OMB
   CFR part or section where identified and described       control No.
------------------------------------------------------------------------
 
                                * * * * *
1.263(a)-5..............................................       1545-1870
 
                                * * * * *
------------------------------------------------------------------------


Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
    Approved: December 19, 2003.
Pamela F. Olson,
Assistant Secretary of the Treasury.
[FR Doc. 03-31823 Filed 12-31-03; 8:45 am]
BILLING CODE 4830-01-P