Part I. Rulings — Internal Revenue Bulletin 2004-7

Section 263.—Capital Expenditures

26 CFR 1.263(a)–1: Capital expenditures; in gen- eral.

T.D. 9107

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1 and 602

Guidance Regarding Deduction and Capitalization of Expenditures

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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 Date : For dates of applicability of the final regulations, see §§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 §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, published in the Bulletin as Announcement 2002–9, 2002–1 C.B. 536 [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, 2003–1 C.B. 373 [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 §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 §1.263(a)–5. Dividing

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strictions 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

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 §1.263(a)–5, while limiting the application of §1.263(a)–4 to costs of acquiring and creating intangibles. The format of the final regulations contained in §§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 §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 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, §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 §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 §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 re

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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.

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 Trea

state that the list contains “examples” of intangibles within the scope of paragraph (c).

D. Created intangibles

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.

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.

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.

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.

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.

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.

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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 §1.263(a)–5 (see Part III of this Preamble). A mutually exclusive rule was not adopted in §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

sury 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.

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 §1.263(a)–5. See Part III of this Preamble (“Explanation and Summary of Comments Concerning §1.263(a)–5”) for a discussion of the treatment of amounts paid to terminate a transaction described in §1.263(a)–5.

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 rule apply only to the extent the taxpayer receives fair market value consideration for the real property.

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 §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 §1.263(a)–5”) for a discussion of the treatment of amounts paid to terminate a transaction described in §1.263(a)–5.

E. Transaction costs

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

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ficult 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 con

(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, §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.

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 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 dif

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or business, a change in the capital structure of a business entity, and certain other transactions. The types of transactions covered by §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 §1.263(a)–4, and not the rules contained in §1.263(a)–5.

Similar to the §1.263(a)–4 final regulations, the §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 §1.263(a)–5 provide a single set of rules for amounts paid to facilitate an

tained 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 §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 §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

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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 §1.263(a)–5, regardless of when the integration activities occur.

Costs Associated with Terminated Transactions

The final regulations clarify when costs of terminating a transaction described in §1.263(a)–5 (including break-up fees) are treated as facilitating another transaction described in §1.263(a)–5. Under the proposed regulations, termination costs facilitate a subsequent transaction if the subsequent transaction is “expressly conditioned” 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 §1.263(a)–5 are similar to the simplifying conventions applicable to acquisitions or creations of intangibles governed by §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 §1.263(a)–4.

The simplifying convention for employee compensation treats amounts paid to persons who are not employees as

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

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).

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.

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.

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.

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.

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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. 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 un

employee compensation if the amounts are paid for secretarial, clerical, or similar administrative support services. In the context of transactions described in §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 §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 §1.263(a)–5. This rule maintains consistency with the rule in §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 com- munication 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

February 17, 2004 454 2004-7 I.R.B.

IV. Effective Dates and Changes in Methods of Accounting

The final regulations under §§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 §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

der 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 §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 §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 §1.167(a)–3.

2004-7 I.R.B. 455 February 17, 2004

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 §601.601(d)(2) of this chapter);

(ii) The intangible asset is described in §1.263(a)–4(c) (relating to intangibles acquired from another person) or §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 §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 §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 §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.

for items addressed in the advance notice of 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 §1.167(a)–3

The final regulations essentially retain the amendments to §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 Reg- ister .

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.

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Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows: