Td 9107

Monday,
January 5, 2004

Part III

Department of the
Treasury
Internal Revenue Service
26 CFR Parts 1 and 602
Guidance Regarding Deduction and
Capitalization of Expenditures; Final Rule

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

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.
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
§§ 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

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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

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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 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

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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.

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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

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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.

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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

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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

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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 § 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.
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

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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
§ 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
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

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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 (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.

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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

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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

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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

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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 or business, a

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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 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.

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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

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441

(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
§ 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 § 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’’

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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 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.

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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

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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.

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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

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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 successbased 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

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443

separate guidance to address the
treatment of these amounts and will
consider at that time whether such
amounts should be eligible for the 15year safe harbor amortization period
described in § 1.167(a)–3.
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 for
items addressed in the advance notice of

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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 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

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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
Accordingly, 26 CFR part 1 is amended
as follows:

■

PART I—INCOME TAXES
Paragraph 1. The authority citation for
part 1 continues to read in part as
follows:

■

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

Par. 2. Section 1.167(a)–3 is amended
by:
■ 1. Designating the text of the section as
paragraph (a) and adding a heading to
newly designated paragraph (a).
■ 2. Adding paragraph (b).
The additions read as follows:
■

§ 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

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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.
(4) Effective date. This paragraph (b)
applies to intangible assets created on or
after December 31, 2003.
Par. 3. Section 1.263(a)–0 is added to
read as follows:

■

§ 1.263(a)–0

Table of contents.

This section lists captioned
paragraphs contained in §§ 1.263(a)–1
through 1.263(a)–5.

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§ 1.263(a)–1
general.

Capital expenditures; in

§ 1.263(a)–2 Examples of capital
expenditures.
§ 1.263(a)–3 Election to deduct or
capitalize certain expenditures.
§ 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 § 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.

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(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.

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445

(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.
§ 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.

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(n) Accounting method changes.
(1) In general.
(2) Scope limitations.
(3) Section 481(a) adjustment.
Par. 4. Sections 1.263(a)–4 and
1.263(a)–5 are added to read as follows:

■

§ 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 § 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.

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(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

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Revenue Bulletin (see § 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
§ 1.446–3(c), the treatment of this fee is
governed by § 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

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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 § 1.197–
2(b)(10)).
(ix) An assembled workforce (as
defined in § 1.197–2(b)(3)).
(x) Goodwill (as defined in § 1.197–
2(b)(1)) or going concern value (as
defined in § 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 § 1.197–2(b)(6)) or supplierbased intangible (as defined in § 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 § 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

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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:

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447

(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

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(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 § 1.263(a)–5.
See § 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 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.

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.

(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):

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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

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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);

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(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

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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

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449

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 5year 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

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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 § 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 § 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 § 1.263(a)–5 for additional rules
regarding termination of merger agreements).

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(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

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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

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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 § 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 § 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.

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451

(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
§§ 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

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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

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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.

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(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

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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

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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

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453

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 9month 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

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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

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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 § 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

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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

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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

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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 12month 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
§ 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 § 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 § 1.461–4 therefore do
not apply to U. The 12-month rule of this
paragraph (f) applies to the $12,000 payment

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455

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 § 1.461–5 does
not apply. Under § 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 12month 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

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Commissioner as provided in § 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 12month 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 § 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.

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(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,

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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
§ 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

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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)

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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 reengineering. (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 justin-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

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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

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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 feeonly 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

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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
§ 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 § 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
§ 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
§ 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.

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(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.
§ 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
§ 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.

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(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 § 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 § 1.263(a)–1, § 1.263(a)–2, and
§ 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 § 1.263(a)–4 is subject to
the rules contained in this section, and
not to the rules contained in § 1.263(a)–
4. In addition, an amount required to be
capitalized by § 1.263(a)–1, § 1.263(a)–2,
or § 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

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459

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
§ 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 § 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

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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

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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

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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—

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(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:

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(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

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461

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 § 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
§ 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 § 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 § 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.

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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

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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 § 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

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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.

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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 breakup 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

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463

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 § 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
§ 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
§ 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.
■ Par. 5. Section 1.446–5 is added to
read as follows:
§ 1.446–5

Debt issuance costs.

(a) In general. This section provides
rules for allocating debt issuance costs

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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 § 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 § 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 § 1.163–7, which generally
require the use of a constant yield
method (as described in § 1.1272–1) to
compute how much original issue
discount is deductible for a period.
However, see § 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 § 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 § 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 § 1.1273–1(d)
($125,000 ($10,000,000 × .0025 × 5)), X must
allocate the original issue discount to each
year based on the constant yield method
described in § 1.1272–1(b). See § 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:

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$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 § 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 § 1.1273–1(d)
($125,000), X does not have to use the
constant yield method described in § 1.1272–
1(b) to allocate the original issue discount to
each year. Instead, under § 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 § 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

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(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

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

§ 602.101

*

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

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*
*
(b) * * *

*

*

*
*
*
1.263(a)–5 ............................

Authority: 26 U.S.C. 7805.

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*

*

*

Current OMB
control No.
*

*

OMB Control numbers.

CFR part or section where
identified and described

■

CFR part or section where
identified and described

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Current OMB
control No.
*

*
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

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