Bulletin No. 2003–5 February 3, 2003 HIGHLIGHTS OF THIS ISSUE · 2012. 7. 17. · Announcement 2003–4, page 396. This announcement contains a correction to Rev. Proc. 2003–7,

HIGHLIGHTSOF THIS ISSUEThese synopses are intended only as aids to the reader inidentifying the subject matter covered. They may not berelied upon as authoritative interpretations.

INCOME TAX

Rev. Rul. 2003–7, page 363.Actual and constructive sales. This ruling holds that a share-holder has neither sold stock currently under section 1001 of theCode nor caused a constructive sale of stock under section 1259if the shareholder receives a fixed amount of cash, simulta-neously enters into an agreement to deliver on a future date anumber of shares of common stock that varies significantly de-pending on the value of the shares on the delivery date, pledgesthe maximum number of shares for which delivery could be re-quired under the agreement, retains an unrestricted legal rightto substitute cash or other shares for the pledged shares, andis not otherwise economically compelled to deliver the pledgedshares.

T.D. 9025, page 362.Final regulations under section 446 of the Code confirm that thetiming rules of the intercompany transaction regulations of sec-tion 1.1502–13 are a method of accounting.

REG–125638–01, page 373.Proposed regulations explain how section 263(a) of the Code ap-plies to amounts paid to acquire, create, or enhance intangibleassets. The regulations also provide safe harbor amortization un-der section 167(a) for certain intangible assets and explain themanner in which taxpayers may deduct debt issuance costs. Apublic hearing is scheduled for April 22, 2003.

Notice 2003–9, page 369.Equity investments prior to allocation. The Treasury Depart-ment and the Service announce that they will amend section1.45D–1T(c)(3)(ii) of the temporary regulations to extend a dead-line relating to certain equity investments made before the re-ceipt of a new markets tax credit allocation under section45D(f)(2) of the Code.

EMPLOYEE PLANS

Notice 2003–10, page 369.Definition of early retirement benefits and retirement-type subsidies. The IRS and the Treasury intend to propose regu-lations and are requesting comments regarding benefits that aretreated as early retirement benefits or retirement-type subsi-dies for purposes of section 411(d)(6)(B) of the Code, includ-ing guidance on the extent to which payments that are contingenton the occurrence of an unpredictable event are protected un-der section 411(d)(6)(B). Notice 2002–46 modified.

EXCISE TAX

T.D. 9024, page 365.Final regulations under section 4374 of the Code relate to liabil-ity for the insurance premium excise tax. The regulations af-fect persons who make, sign, issue, or sell a policy of insurance,indemnity bond, annuity contract, or policy of reinsurance is-sued by any foreign insurer or reinsurer.

(Continued on the next page)

Bulletin No. 2003–5February 3, 2003

Findings Lists begin on page ii.Index for January begins on page iv.

ADMINISTRATIVE

T.D. 9026, page 366.Final regulations under section 7526 of the Code exclude cer-tain low-income taxpayer clinics (LITCs) that qualify for grants fromthe definition of income tax return preparer under section7701(a)(36). The regulations also exclude certain persons whoare employed by, or volunteer for, such clinics.

Rev. Proc. 2003–19, page 371.This procedure provides guidance on the administrative appealrights of a spouse or former spouse when a taxpayer seeks in-nocent spouse relief from federal income tax liability under sec-tion 6015 of the Code.

Announcement 2003–4, page 396.This announcement contains a correction to Rev. Proc. 2003–7,2003–1 I.R.B. 233.

Announcement 2003–5, page 397.This advance notice of proposed regulations invites individualsand organizations to submit comments on revising the rules gov-erning practice before the IRS (Circular No. 230) to address cer-tain issues regarding standards of practice of attorneys, certifiedpublic accountants, enrolled agents, enrolled actuaries and ap-praisers who represent taxpayers before the Service.

February 3, 2003 2003–5 I.R.B.

The IRS Mission

Provide America’s taxpayers top quality service by helping themunderstand and meet their tax responsibilities and by applyingthe tax law with integrity and fairness to all.

IntroductionThe Internal Revenue Bulletin is the authoritative instrument of theCommissioner of Internal Revenue for announcing official rul-ings and procedures of the Internal Revenue Service and for pub-lishing Treasury Decisions, Executive Orders, Tax Conventions,legislation, court decisions, and other items of general inter-est. It is published weekly and may be obtained from the Super-intendent of Documents on a subscription basis. Bulletin contentsare consolidated semiannually into Cumulative Bulletins, whichare sold on a single-copy basis.

It is the policy of the Service to publish in the Bulletin all sub-stantive rulings necessary to promote a uniform application ofthe tax laws, including all rulings that supersede, revoke, modify,or amend any of those previously published in the Bulletin. All pub-lished rulings apply retroactively unless otherwise indicated. Pro-cedures relating solely to matters of internal management arenot published; however, statements of internal practices and pro-cedures that affect the rights and duties of taxpayers are pub-lished.

Revenue rulings represent the conclusions of the Service on theapplication of the law to the pivotal facts stated in the revenueruling. In those based on positions taken in rulings to taxpay-ers or technical advice to Service field offices, identifying de-tails and information of a confidential nature are deleted to preventunwarranted invasions of privacy and to comply with statutoryrequirements.

Rulings and procedures reported in the Bulletin do not have theforce and effect of Treasury Department Regulations, but theymay be used as precedents. Unpublished rulings will not be re-lied on, used, or cited as precedents by Service personnel in thedisposition of other cases. In applying published rulings and pro-cedures, the effect of subsequent legislation, regulations, court

decisions, rulings, and procedures must be considered, and Ser-vice personnel and others concerned are cautioned against reach-ing the same conclusions in other cases unless the facts andcircumstances are substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.This part includes rulings and decisions based on provisions ofthe Internal Revenue Code of 1986.

Part II.—Treaties and Tax Legislation.This part is divided into two subparts as follows: Subpart A, TaxConventions and Other Related Items, and Subpart B, Legisla-tion and Related Committee Reports.

Part III.—Administrative, Procedural, and Miscellaneous.To the extent practicable, pertinent cross references to these sub-jects are contained in the other Parts and Subparts. Also in-cluded in this part are Bank Secrecy Act Administrative Rulings.Bank Secrecy Act Administrative Rulings are issued by the De-partment of the Treasury’s Office of the Assistant Secretary (En-forcement).

Part IV.—Items of General Interest.This part includes notices of proposed rulemakings, disbar-ment and suspension lists, and announcements.

The first Bulletin for each month includes a cumulative index forthe matters published during the preceding months. Thesemonthly indexes are cumulated on a semiannual basis, and arepublished in the first Bulletin of the succeeding semiannual pe-riod, respectively.

The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.

For sale by the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402.

2003–5 I.R.B. February 3, 2003

Part I. Rulings and Decisions Under the Internal Revenue Code of 1986

Section 446.—General Rulefor Methods of Accounting

26 CFR 1.446–1: General rule for methods ofaccounting.

T.D. 9025

DEPARTMENT OF THETREASURYInternal Revenue Service26 CFR Part 1

Intercompany Transactions:Conforming Amendments toSection 446

AGENCY: Internal Revenue Service (IRS),Treasury.

ACTION: Final regulations.

SUMMARY: On July 18, 1995, the Trea-sury Department and the IRS published fi-nal regulations governing the intercompanytransaction system of the consolidated re-turn regulations. Those regulations state thatthe timing rules of the intercompany trans-action system are a method of account-ing. At the time of the publication of thoseregulations, no amendment was made to theregulations promulgated under section 446to coordinate with that statement. This docu-ment contains final regulations confirm-ing that the timing rules of the intercompanytransaction regulations are a method of ac-counting. These regulations apply to all tax-payers filing consolidated returns.

DATES: Effective Date: These regulationsare effective on December 16, 2002.

Applicability Date: These regulations ap-ply to consolidated return years begin-ning on or after November 7, 2001.

FOR FURTHER INFORMATIONCONTACT: Vincent Daly, (202) 622–7770,or Jeffery G. Mitchell (202) 622–4930 (nottoll-free numbers).

SUPPLEMENTARY INFORMATION:

Background and Explanation ofProvisions

On July 18, 1995, the Treasury Depart-ment and the IRS published in the Fed-

eral Register (T.D. 8597, 1995–2 C.B. 147[60 FR 36671]) final regulations under§ 1.1502–13 governing the intercompanytransaction system of the consolidated re-turn regulations. Included in such regula-tions was an express statement that “[t]hetiming rules of [the intercompany transac-tion regulations] are a method of account-ing for intercompany transactions, to beapplied by each member in addition to themember’s other methods of accounting.”§ 1.1502–13(a)(3)(i). At the time of the pub-lication of those final regulations, noamendment was made to the regulationspromulgated under section 446 to coordi-nate with the statement in § 1.1502–13(a)(3)(i) that the timing rules of§ 1.1502–13 are a method of accounting.

In General Motors v. Commissioner, 112T.C. 270 (1999), the Tax Court determinedthat the timing rule of former § 1.1502–13(b)(2) was not a method of accountingfor purposes of section 446(e). On Novem-ber 7, 2001, the Treasury and the IRS pub-lished in the Federal Register a notice ofproposed rulemaking (REG–125161–01,2001–2 C.B. 538 [66 FR 56262]) propos-ing amendments to CFR part 1 under sec-tion 446 of the Internal Revenue Code toconfirm that the timing rules of § 1.1502–13are a method of accounting. No writtencomments responding to the notice of pro-posed rulemaking were received, and nopublic hearing was requested or held. There-fore, the proposed regulations are adoptedby this Treasury decision without change.

Special Analyses

It has been determined that this Trea-sury decision is not a significant regula-tory action as defined in Executive Order12866. Therefore, a regulatory assessmentis not required. It also has been determinedthat section 553(b) of the AdministrativeProcedure Act (5 U.S.C. chapter 5) does notapply to these regulations. Because the regu-lations do not impose a collection of in-formation on small entities, the RegulatoryFlexibility Act (5 U.S.C. chapter 6) does notapply. Pursuant to section 7805(f) of the In-ternal Revenue Code, the notice of pro-posed rulemaking preceding theseregulations was submitted to the ChiefCounsel for Advocacy of the Small Busi-ness Administration for comment on its

impact on small business.

Drafting Information

The principal author of these regula-tions is Vincent Daly, Office of the Asso-ciate Chief Counsel (Corporate). However,other personnel from the IRS and Trea-sury Department participated in their de-velopment.

* * * * *

Adoption of Amendments to theRegulations

Accordingly, 26 CFR part 1 is amendedas follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * *Par. 2. Section 1.446–1 is amended by

adding paragraph (c)(2)(iii) to read asfollows:

§ 1.446–1 General rule for methods ofaccounting.

* * * * *(c) * * *(2) * * * (i) * * *(iii) The timing rules of § 1.1502–13 are

a method of accounting for intercompanytransactions (as defined in § 1.1502–13(b)(1)(i)), to be applied by each mem-ber of a consolidated group in addition tothe member’s other methods of account-ing. See § 1.1502–13(a)(3)(i). This para-graph (c)(2)(iii) is applicable to consolidatedreturn years beginning on or after Novem-ber 7, 2001.

* * * * *

Par. 3. In § 1.1502–13, the second sen-tence of paragraph (a)(3)(i) is revised toread as follows:

§ 1.1502–13 Intercompany transactions.

(a) * * *(3)* * * (i) * * * See § 1.1502–17 and,

with regard to consolidated return years be-ginning on or after November 7, 2001,§ 1.446–1(c)(2)(iii). * * *

* * * * *

2003–5 I.R.B. 362 February 3, 2003

David A. Mader,Assistant Deputy Commissioner of

Internal Revenue.

Approved December 9, 2002.

Pamela F. Olson,Assistant Secretary of

the Treasury (Tax Policy).

(Filed by the Office of the Federal Register on December 13,2002, 8:45 a.m., and published in the issue of the Federal Reg-ister for December 16, 2003, 67 F.R. 76985)

Section 1001.—Determina-tion of Amount of andRecognition of Gain or Loss

26 CFR 1.1001–1:Determination and recognitionof gain or loss.

(Also § 1259.)

Actual and constructive sales. This rul-ing holds that a shareholder has neither soldstock currently under section 1001 of theCode nor caused a constructive sale of stockunder section 1259 if the shareholder re-ceives a fixed amount of cash, simulta-neously enters into an agreement to deliveron a future date a number of shares of com-mon stock that varies significantly depend-ing on the value of the shares on thedelivery date, pledges the maximum num-ber of shares for which delivery could berequired under the agreement, retains an un-restricted legal right to substitute cash orother shares for the pledged shares, and isnot otherwise economically compelled todeliver the pledged shares.

Rev. Rul. 2003–7

ISSUES

Has a shareholder either sold stock cur-rently or caused a constructive sale of stockunder § 1259 of the Internal Revenue Codeif the shareholder (1) receives a fixedamount of cash, (2) simultaneously entersinto an agreement to deliver on a future datea number of shares of common stock thatvaries significantly depending on the valueof the shares on the delivery date, (3)pledges the maximum number of shares forwhich delivery could be required under theagreement, (4) has the unrestricted legalright to deliver the pledged shares or to sub-stitute cash or other shares for the pledged

shares on the delivery date, and (5) is noteconomically compelled to deliver thepledged shares?

FACTS

An individual (“Shareholder”) heldshares of common stock in Y corporation,which is publicly traded. Shareholder’s ba-sis in the shares of Y corporation is less than$20 per share. On September 15, 2002 (the“Execution Date”), Shareholder entered intoan arm’s length agreement (the “Agree-ment”) with Investment Bank, at which timea share of common stock in Y corpora-tion had a fair market value of $20. Share-holder received $z of cash upon executionof the Agreement. In return, Shareholder be-came obligated to deliver to InvestmentBank on September 15, 2005 (the “Ex-change Date”), a number of shares of com-mon stock of Y corporation to bedetermined by a formula. Under the for-mula, if the market price of a share of Ycorporation common stock is less than $20on the Exchange Date, Investment Bankwill receive 100 shares of common stock.If the market price of a share is at least $20and no more than $25 on the ExchangeDate, Investment Bank will receive a num-ber of shares having a total market valueequal to $2000. If the market price of ashare exceeds $25 on the Exchange Date,Investment Bank will receive 80 shares ofcommon stock. In addition, Shareholder hasthe right to deliver to Investment Bank onthe Exchange Date cash equal to the valueof the common stock that Shareholderwould otherwise be required to deliver un-der the formula.

In order to secure Shareholder’s obli-gations under the Agreement, Shareholderpledged to Investment Bank on the Execu-tion Date 100 shares (that is, the maxi-mum number of shares that Shareholdercould be required to deliver under theAgreement). Shareholder effected thispledge by transferring the shares in trust toa third-party trustee, unrelated to Invest-ment Bank. Under the declaration of trust,Shareholder retained the right to vote thepledged shares and to receive dividends.

Under the Agreement, Shareholder hadthe unrestricted legal right to deliver thepledged shares, cash, or shares other thanthe pledged shares to satisfy its obliga-tion under the Agreement. Shareholder isnot otherwise economically compelled todeliver the pledged shares. At the time

Shareholder and Investment Bank enteredinto the Agreement, however, Shareholderintended to deliver the pledged shares to In-vestment Bank on the Exchange Date in or-der to satisfy Shareholder’s obligationsunder the Agreement.

LAW AND ANALYSIS

Section 1001(c) provides that, except asotherwise provided in subtitle A of theCode, the entire amount of gain or loss, de-termined under § 1001, on the sale or ex-change of property shall be recognized. TheCode does not define a “sale or exchange.”The courts have considered many factorssignificant in determining whether a sale orother disposition of property has occurred.The factors that are relevant, and the weightto be accorded to each factor, must be de-termined in light of the nature of the prop-erty involved. See Torres v. Commissioner,88 T.C. 702, 721 (1987).

Several cases have addressed the trans-fer of securities to a brokerage firm un-der a subordination agreement intended toallow the brokerage firm to use the secu-rities to meet its net capital requirementsunder stock exchange rules. See, e.g.,Cruttenden v. U.S., 644 F.2d 1368 (9th Cir.1981); Lorch v. Commissioner, 70 T.C. 674(1978), aff’d, 605 F.2d 657 (2d Cir. 1979),cert. denied, 444 U.S. 1076 (1980); Mi-ami National Bank v. Commissioner, 67T.C. 793 (1977). In these cases, an ownerof marketable securities transferred legal titleand actual possession of the securities to thebrokerage firm, which held the securities ina subordination account under an agree-ment that permitted the brokerage firm tosell the securities if necessary to meetclaims of general creditors of the broker-age firm. The transferor, however, retainedthe right to receive dividends and the rightto vote any stock. In addition, the trans-feror could reacquire the securities in thesubordination account by substituting ei-ther cash or other securities of equivalentvalue.

In Miami National Bank, the court heldthat despite the right of the brokerage firmto sell stock in a subordination account tosatisfy its creditors, the transferor remainedthe owner of the stock. As a result, the courtheld that the transferor’s subsequent sale ofthe stock in the subordination account waseffective to permit the purchaser to betreated as the direct owner of the stock forpurposes of the consolidated return own-

February 3, 2003 363 2003–5 I.R.B.

ership test. At all times, the transferor hadthe right to reacquire the stock in the sub-ordination account by substituting cash orother readily marketable securities ofequivalent value. The court gave signifi-cant weight to this right in holding that thecreation of the subordination account didnot cause the brokerage firm to become theowner of the stock in the subordination ac-count. The court noted that the transfer-or’s right of substitution was not “merelyan idle one” because, at all times, the trans-feror possessed sufficient resources to ex-ercise the right. In fact, after the brokeragefirm became insolvent, the transferor sub-stituted cash for the stock. Thus, Miami Na-tional Bank and other similar cases indicatethat a transfer of actual possession of stockor securities and legal title may not itselfbe sufficient to constitute a transfer of ben-eficial ownership when the transferor re-tains the unrestricted right and ability toreacquire the securities.

In cases addressing short sales of stockor securities, the courts have refused to rec-ognize covering purchases as triggering asale because, until actual delivery, the tax-payer retains the unrestricted right to dis-pose of the covering shares. See, e.g.,Richardson v. Commissioner, 121 F.2d 1 (2dCir.), cert. denied, 314 U.S. 684 (1941). Ina typical short sale, the taxpayer borrowsstock or securities to effect a short sale andis under an obligation to return identicalstock or securities to the lender. InRichardson, the taxpayer entered into nu-merous sales, which were generally shortsales effected with borrowed stock. In onecase, the taxpayer purchased 7,100 sharesof stock that were intended to be used toclose out a short sale but were in fact de-livered to close out a different sale. De-spite the taxpayer’s intent to use thepurchased stock to close his earliest openshort sale, and despite a showing that he fol-lowed a consistent practice of applying pur-chases to close out his earliest open shortsale, the taxpayer was held not to haveclosed a short sale because the stock wasnot actually delivered to the stock lender.Noting that the taxpayer had not enteredinto any agreement or understanding withthe lender of the 7,100 shares and had nototherwise placed himself in a position inwhich he was not entitled to treat the pur-chased shares as long stock and sell themfor his own account, the court stated:

[The covering shares] remained undercontrol of the taxpayer and up to thetime of actual delivery could have beensold and replaced by other purchases inthe absence of prior agreement with thelender to use them to make restitution.Such a shifting intent to cover a shortsale ought not to be the critical eventwhich would determine gain or loss un-der a tax statute. It would leave thewhole matter of fixing the event to thetaxpayer’s own will. We hold that thetime of delivery was the time at whichthe covering transactions must be re-garded as closed.

Richardson at 4. Accord Klinger v. Com-missioner, No. 18315 (T.C.M. 1949). Thus,Richardson supports the conclusion thateven if the shareholder intends to com-plete a sale by delivering identified stock,that intent alone does not cause a transac-tion to be deemed a sale, as long as the tax-payer retains the right to determine whetherthe identified stock will in fact be deliv-ered.

By contrast, in Hope v. Commissioner,55 T.C. 1020 (1971), aff’d, 471 F.2d 738(3d Cir.), cert. denied, 414 U.S. 824 (1973),the Tax Court, in determining that a sale hadoccurred, relied on the seller’s receipt ofsales proceeds and the purchaser’s receiptof title and possession of shares without re-striction in use. In that case, the taxpayerwas the owner of approximately 57% of thecommon stock of a company that had re-cently become a publicly traded company,and was having difficulty in disposing ofhis remaining large block of stock. The tax-payer made an arrangement with an in-vestment bank for a sale at a price that wasapproximately one half of the price at whichthe stock was currently trading. Under thearrangement, the investment bank earned itsfee by reselling 25% of the block of stockto the general public. The investment bankheld the remainder of the stock subject tooptions to purchase the stock at the invest-ment bank’s cost and subject to proxyagreements that transferred to the option-ees the right to vote the shares for the elec-tion of directors. Half of the options andproxy rights were held by the taxpayer’sbrother; the other half were held by two in-dividuals who were employees of the com-pany. Subsequent to the closing of thetransaction, the taxpayer became dissatis-fied with the sale price and brought a suitfor rescission. The litigation was not con-

cluded in the year of the transaction. On ad-vice of counsel, the taxpayer held the salesproceeds in cash and marketable securi-ties pending settlement of the litigation. Onhis tax return for the year of the transfer,the taxpayer disclosed the transfer but didnot include in income his gain on the saleon the ground that the transfer was not acompleted sale on which gain was recog-nized.

The court concluded that the transac-tion constituted a sale of the entire block:

The facts of this case conclusively es-tablish that on July 27, 1960, the peti-tioner sold 206,400 shares of . . . stockto [an investment bank] as agent for sev-eral purchasers as well as for its own ac-count. The sale was completed on thatdate when title and possession of the cer-tificates were transferred by the peti-tioner to [the investment bank], and thepetitioner received $4,000,032 as pay-ment in full. . . . The petitioner receivedthe money from the sale without any re-strictions on his use or disposition ofthose funds.

55 T.C. at 1029.In the present case, on the Execution

Date, Shareholder received a fixed pay-ment without any restriction on its use andalso transferred in trust the maximum num-ber of shares that might be required to bedelivered under the Agreement. Like thetaxpayers in Miami National Bank andRichardson, but unlike the taxpayer inHope, Shareholder retained the right to re-ceive dividends and exercise voting rightswith respect to the pledged shares. Also un-like Hope, the legal title to, and actual pos-session of, the shares were transferred to anunrelated trustee rather than to InvestmentBank. Moreover, Shareholder was not re-quired by the terms of the Agreement tosurrender the shares to Investment Bank onthe Exchange Date. Rather, Shareholder hada right, unrestricted by agreement or eco-nomic circumstances, to reacquire the shareson the Exchange Date by delivering cashor other shares. See Miami National Bankand Richardson. Accordingly, the execu-tion of the Agreement did not cause a saleor other disposition of the shares.

A different outcome may be warrantedif a shareholder is under any legal restraintor requirement or under any economic com-pulsion to deliver pledged shares rather thanto exercise a right to deliver cash or othershares. For example, restrictions placed

2003–5 I.R.B. 364 February 3, 2003

upon a shareholder’s right to own pledgedcommon stock after the Exchange Date, oran expectation that a shareholder will lacksufficient resources to exercise the right todeliver cash or shares other than pledgedshares, would be significant factors to beweighed in determining whether a sale hasoccurred.

Section 1259(a)(1) provides that, if thereis a constructive sale of an appreciated fi-nancial position, the taxpayer shall recog-nize gain as if such position were sold,assigned, or otherwise terminated at its fairmarket value on the date of such construc-tive sale. Under § 1259(b), the term “ap-preciated financial position” means anyposition with respect to any stock, debt in-strument, or partnership interest if therewould be gain were such position sold, as-signed, or otherwise terminated at its fairmarket value. Furthermore, for purposes of§ 1259, the term “position” means an in-terest, including a futures or forward con-tract, short sale, or option.

Under § 1259(c)(1)(C), a taxpayer istreated as having made a constructive saleof an appreciated financial position if thetaxpayer (or a related person) enters into afutures or forward contract to deliver thesame or substantially identical property. Theterm “forward contract” is defined under§ 1259(d)(1) as a contract to deliver a sub-stantially fixed amount of property (includ-ing cash) for a substantially fixed price. Thelegislative history indicates that a forwardcontract that provides for the delivery of anamount of stock that is subject to “signifi-cant variation” under the terms of the con-tract is not within the statutory definitionof a forward contract. S. Rep. No. 33, 105thCong., 1st Sess. 125–26 (1997), 1997–4(Vol. 2) C.B. 1067, 1205–06.

Under these facts, the Agreement doesnot cause a constructive sale of the sharesunder § 1259(c)(1)(C). According to theAgreement, delivery of a number of shares,which may vary between 80 and 100 shares,depends on the fair market value of thestock on the Exchange Date. Because thisvariation in the number of shares that maybe delivered under the Agreement is a sig-nificant variation, the Agreement is not acontract to deliver a substantially fixedamount of property for purposes of§ 1259(d)(1). As a result, the Agreementdoes not meet the definition of a forward

contract under § 1259(d)(1) and does notcause a constructive sale under§ 1259(c)(1)(C).

HOLDING

Shareholder has neither sold stock cur-rently nor caused a constructive sale ofstock if Shareholder receives a fixed amountof cash, simultaneously enters into an agree-ment to deliver on a future date a numberof shares of common stock that varies sig-nificantly depending on the value of theshares on the delivery date, pledges themaximum number of shares for which de-livery could be required under the agree-ment, retains an unrestricted legal right tosubstitute cash or other shares for thepledged shares, and is not economicallycompelled to deliver the pledged shares.

DRAFTING INFORMATION

The principal authors of this revenue rul-ing are Christina Morrison and MaryTruchly of the Office of Associate ChiefCounsel (Financial Institutions and Prod-ucts). For further information regarding thisrevenue ruling, contact Ms. Morrison at(202) 622–3950 or Ms. Truchly at (202)622–3960 (not toll-free calls).

Section 4374.—Liability forTax

26 CFR 46.4374–1: Liability for tax.

T.D. 9024


Liability For InsurancePremium Excise Tax



SUMMARY: This document contains fi-nal regulations under section 4374 relat-ing to liability for the insurance premiumexcise tax. This document affects persons

who make, sign, issue, or sell a policy ofinsurance, indemnity bond, annuity con-tract, or policy of reinsurance issued by anyforeign insurer or reinsurer.

DATES: Effective Date: These regulationsare effective November 27, 2002.

Applicability Date: These regulations areapplicable to premiums paid on or after No-vember 27, 2002.

FOR FURTHER INFORMATIONCONTACT: David Lundy at (202) 622–3880 (not a toll-free number).


Background

On January 7, 2002, the IRS and Trea-sury published a notice of proposed rule-making (REG–125450–01, 2002–5 I.R.B.457) in the Federal Register (67 FR 707)under section 4374 relating to the insur-ance premium excise tax imposed by sec-tion 4371 on certain policies issued byforeign insurance and reinsurance compa-nies. One comment letter responding to thenotice of proposed rulemaking was re-ceived. After consideration of these com-ments, the proposed regulations are adoptedas final regulations as revised by this Trea-sury decision.

Explanation of Provisions

These final section 4374 regulationsclarify the persons who are liable for pay-ment of the insurance premium excise taxand conform the regulations to the amend-ments made to section 4374 by the Tax Re-form Act of 1976 (90 Stat. 1525). Inparticular, these regulations clarify that li-ability for the excise tax is incurred by anyperson who makes, signs, issues, or sellsany of the documents and instruments sub-ject to the tax, or for whose use or ben-efit the same are made, signed, issued, orsold.

One commentator suggested that the fi-nal regulation restrict application of the sec-tion 7270 penalty to a failure to pay theexcise tax by the person who remitted thetax to the foreign insurer or reinsurer. Sec-tion 46.4374–1(d) of the regulation only isa cross-reference to section 7270, whichsection imposes a penalty of double theamount of tax when an underpayment re-

February 3, 2003 365 2003–5 I.R.B.

sults from an intention to evade the tax.Substantive guidance on the application ofsection 7270 is beyond the scope of thisregulation, and accordingly, no change tothe regulation was made as a result of thissuggestion.

The same commentator suggested thatthe final regulation clarify whether the in-sured person under an insurance policy maybe liable for the excise tax if all or a por-tion of the risks from such policy are re-insured with a foreign reinsurer on the basisthat the insured may be treated as a per-son for whose benefit the reinsurance policywas made, signed, issued, or sold. In re-sponse to the commentator’s suggestion,§ 46.4374–1(a) of these regulations has beenrevised to provide that in the case of a re-insurance policy other than assumption re-insurance, the insured person on theunderlying insurance policy, the risk ofwhich is covered in whole or in part bysuch reinsurance policy, shall not consti-tute a person for whose use or benefit thereinsurance policy was made, signed, is-sued or sold. In these cases, when an in-surer or reinsurer reinsures a risk with aforeign reinsurer, the insurer or reinsurergenerally is the person for whose use orbenefit the reinsurance policy is issued orsold for purposes of section 4374.

Effective Date

The final regulations are effective forpremiums paid on or after November 27,2002.

Special Analyses

It has been determined that this Trea-sury decision is not a significant regula-tory action as defined in Executive Order12866. Therefore, a regulatory assessmentis not required. It has also been determinedthat section 553(b) of the AdministrativeProcedure Act (5 U.S.C. chapter 5) does notapply to these regulations, and because theseregulations do not impose a collection ofinformation on small entities, the Regula-tory Flexibility Act (5 U.S.C. chapter 6)does not apply. Therefore, a RegulatoryFlexibility Analysis is not required. Pur-suant to section 7805(f) of the Internal Rev-enue Code, the notice of proposedrulemaking preceding these regulations wassubmitted to the Chief Counsel for Advo-cacy of the Small Business Administra-tion for comment on its impact on smallbusiness.


The prinicipal author of these regula-tions is David Lundy of the Office of As-sociate Chief Counsel (International).However, other personnel from the IRS andTreasury Department participated in theirdevelopment.

* * * * *


Accordingly, 26 CFR part 46 is amendedas follows:

PART 46 — EXCISE TAX ONPOLICIES ISSUED BY FOREIGNINSURERS AND OBLIGATIONS NOTIN REGISTERED FORM

Paragraph 1. The authority citation forpart 46 continues to read as follows:

Authority: 26 U.S.C. 7805.Par. 2. Section 46.4374–1 is revised to

read as follows:

§ 46.4374–1 Liability for tax.

(a) In general. Any person who makes,signs, issues, or sells any of the documentsand instruments subject to the tax, or forwhose use or benefit the same are made,signed, issued, or sold, shall be liable forthe tax imposed by section 4371. For pur-poses of this section, in the case of a re-insurance policy that is subject to the taximposed by section 4371(3), other than as-sumption reinsurance, the insured person onthe underlying insurance policy, the risk ofwhich is covered in whole or in part bysuch reinsurance policy, shall not consti-tute a person for whose use or benefit thereinsurance policy is made, signed, is-sued, or sold.

(b) When liability for tax attaches. Theliability for the tax imposed by section 4371shall attach at the time the premium pay-ment is transferred to the foreign insurer orreinsurer (including transfers to any bank,trust fund, or similar recipient, designatedby the foreign insurer or reinsurer), or toany nonresident agent, solicitor, or bro-ker. A person required to pay tax under thissection may remit such tax before the timethe tax attaches if he keeps records con-sistent with such practice.

(c) Payment of tax. The tax imposed bysection 4371 shall be paid on the basis ofa return by the person who makes pay-

ment of the premium to a foreign insureror reinsurer or to any nonresident agent, so-licitor, or broker. If the tax is not paid bythe person who paid the premium, the taximposed by section 4371 shall be paid onthe basis of a return by any person whomakes, signs, issues, or sells any of thedocuments or instruments subject to the taximposed by section 4371, or for whose useor benefit such document or instrument ismade, signed, issued, or sold.

(d) Penalty for failure to pay tax. Anyperson who fails to comply with the re-quirements of this section with intent toevade the tax shall, in addition to other pen-alties provided therefor, pay a fine of doublethe amount of tax. (See section 7270.)

(e) Effective date. This section is appli-cable for premiums paid on or after No-vember 27, 2002.

Robert E. Wenzel,Deputy Commissioner of

Internal Revenue.

Approved November 13, 2002.

Pamela F. Olson,Assistant Secretary of the

Treasury (Tax Policy).

(Filed by the Office of the Federal Register on November 26,2002, 8:45 a.m., and published in the issue of the Federal Reg-ister for November 27, 2002, 67 F.R. 70845)

Section 7701.—Definitions

26 CFR 301.7701–15: Income tax return preparer.

T.D. 9026


Low-Income TaxpayerClinics—Definition of IncomeTax Return Preparer



SUMMARY: This document contains fi-nal regulations that exclude certain Low-Income Taxpayer Clinics (LITCs) thatqualify for grants under section 7526 of theInternal Revenue Code from the defini-

2003–5 I.R.B. 366 February 3, 2003

tion of income tax return preparer undersection 7701(a)(36). These final regula-tions also exclude certain persons who areemployed by, or volunteer for, such clin-ics.

DATES: Effective Date: These regula-tions are effective December 18, 2002.

Applicability Date: These regulations ap-ply to returns that are prepared on or af-ter December 18, 2002.

FOR FURTHER INFORMATIONCONTACT: Brinton T. Warren at (202)622–4940 (not a toll-free number).


Background

This document contains amendments tothe Regulations on Procedure and Admin-istration (26 CFR part 301) relating to thedefinition of the term income tax return pre-parer under section 7701(a)(36) of the In-ternal Revenue Code (Code). On June 11,2002, a notice of proposed rulemaking waspublished in the Federal Register (REG–115285–01, 2002–27 I.R.B. 62 [67 FR39915]). One comment was received in re-sponse to the notice of proposed rulemak-ing. No public hearing was requested orheld. After consideration of the comment,the proposed regulations under section7701(a)(36) are adopted.

These regulations have been promul-gated in furtherance of the purposes of Sec-tion 3601(a) of the Internal Revenue ServiceRestructuring and Reform Act of 1998, Pub-lic Law 105–206 (112 Stat. 685) (1998)(RRA 1998). Section 3601(a), which addedsection 7526 of the Code, provides grantsto qualified LITCs. Qualified LITCs rep-resent taxpayers in controversies with theIRS and operate programs to inform indi-viduals for whom English is a second lan-guage (ESL taxpayers) about their rights andresponsibilities as taxpayers (ESL outreach).Qualified LITCs are either clinical pro-grams run by accredited educational insti-tutions that allow students to represent low-income taxpayers, or tax-exemptorganizations that provide representation tolow-income taxpayers.

Section 7701(a)(36), defining the termincome tax return preparer, was enacted bysection 1203 of the Tax Reform Act of1976, Public Law 94–455 (90 Stat. 1520)(1976) (TRA 1976). TRA 1976 also en-acted many of the provisions of sections

6694 and 6695, which impose penalties forcertain acts and omissions by income taxreturn preparers.

The preparer penalties enacted by TRA1976 reflect the concern of Congress withimproper practices within the commercialtax services industry. See H. R. Rep. No.94–658, 94th Cong. 1st Sess. 274 (1976),1976–3 (Vol. 2) C.B. 966. Consistent withthe commercial focus of the legislative his-tory, the definition of an income tax re-turn preparer requires that the tax return orclaim for refund be prepared “for compen-sation.” Persons who do not receive com-pensation are not income tax returnpreparers for purposes of section7701(a)(36) regardless of the extent towhich they are involved with the prepara-tion of a return or claim for refund.

Under section 7526(b)(1)(A)(i), a quali-fied LITC may not charge more than anominal fee for its authorized services (ex-cept for reimbursement of actual costs in-curred). These final regulations, consistentwith the notice of proposed rulemaking,specify the circumstances in which an LITCmay receive a nominal fee that will not beconsidered compensation for purposes ofsection 7701(a)(36).

Explanation of Revisions andSummary of Comment

These final regulations adopt the pro-posed amendments without substantivechange. Under these final regulations, quali-fied LITCs, as defined by section 7526, andemployees and volunteers of such LITCs,that provide assistance with a tax return orclaim for refund will not be treated as in-come tax return preparers if two require-ments are satisfied.

First, any such return preparation assis-tance must be (i) directly related to a con-troversy with the IRS for which the LITCis providing assistance or (ii) an ancillarypart of an LITC’s ESL outreach program.Second, the LITC cannot charge a sepa-rate fee or vary a fee based on whether theLITC provides assistance with a return oftax or claim for refund, or charge more thana nominal fee for its services. The regula-tions apply to returns prepared on or af-ter December 18, 2002.

The commentator focused on the scopeof the direct relation requirement that ap-plies to LITCs that represent taxpayers incontroversies. The commentator observedthat, for a nonfiler to obtain the benefits of

an offer in compromise or installment agree-ment, it is sometimes necessary for an LITCto prepare a number of the nonfiler’s re-turns for prior years. The commentator re-quested clarification as to whetherpreparation of the prior-year returns is di-rectly related to the nonfiler’s controversywith the IRS. As in the commentator’s ex-ample, in cases where the preparation of ataxpayer’s return is required to resolve acontroversy for which an LITC is repre-senting a taxpayer, such preparation wouldbe treated under these final regulations asdirectly related to that controversy.

These regulations do not address thedefinition of a nominal fee. The TreasuryDepartment and the IRS specifically re-quested comments on the need for a defi-nition of a nominal fee and the factors thatshould be considered in defining a nomi-nal fee. No comments were received on thistopic. The Treasury Department and the IRSconclude that the definition of nominal feeshould not be addressed in these regula-tions at this time. The final regulations donot specifically address the qualificationsof an LITC under section 7526. The Trea-sury Department and IRS reiterate the view,originally stated in the preamble of the pro-posed regulations, that a qualified LITCmay not provide return preparation assis-tance other than assistance directly re-lated to a controversy with the IRS orassistance that is an ancillary part of an ESLoutreach program.

Special Analyses

It has been determined that this Trea-sury decision is not a significant regula-tory action as defined in Executive Order12866. Therefore, a regulatory assessmentis not required. It also has been determinedthat section 553(b) of the AdministrativeProcedure Act (5 U.S.C. chapter 5) does notapply to these regulations, and, becausethese regulations do not impose a collec-tion of information on small entities, theRegulatory Flexibility Act (5 U.S.C. chap-ter 6) does not apply. Pursuant to section7805(f) of the Code, the notice of pro-posed rulemaking preceding these regula-tions was submitted to the Chief Counselfor Advocacy of the Small Business Ad-ministration for comment on their impact.


The principal author of the regulations

February 3, 2003 367 2003–5 I.R.B.

is Brinton T. Warren of the Office of As-sociate Chief Counsel (Procedure and Ad-ministration), Administrative Provisions andJudicial Practice Divison.

* * * * *


Accordingly, 26 CFR part 301 isamended as follows:

PART 301—PROCEDURE ANDADMINISTRATION


Authority: 26 U.S.C. 7805 * * *Par. 2. Section 301.7701–15 is amended

by:1. Removing the language “and” at the

end of paragraph (a)(7)(iii).2. Removing the period at the end of

paragraph (a)(7)(iv) and adding a semico-lon in its place.

3. Adding paragraphs (a)(7)(v) through(a)(7)(viii).

The additions read as follows:

§ 301.7701–15 Income tax returnpreparer.

* * * * *(a) * * *(7) * * *(v) Any individual who provides tax as-

sistance as part of a qualified Low-IncomeTaxpayer Clinic (LITC), as defined by sec-tion 7526, subject to the requirements ofparagraphs (a)(7)(vii) and (viii) of this sec-tion; and

(vi) Any organization that is a quali-fied Low-Income Taxpayer Clinic (LITC),as defined by section 7526, subject to therequirements of paragraphs (a)(7)(vii) and(viii) of this section.

(vii) Paragraphs (a)(7)(v) and (vi) of thissection apply only if any assistance with areturn of tax or claim for refund under sub-title A is directly related to a controversywith the Internal Revenue Service for whichthe qualified LITC is providing assistance,or is an ancillary part of an LITC pro-gram to inform individuals for whom En-glish is a second language about their rightsand responsibilities under the Internal Rev-enue Code.

(viii) Notwithstanding paragraph(a)(7)(vii) of this section, paragraphs(a)(7)(v) and (vi) of this section do not ap-ply if an LITC charges a separate fee orvaries a fee based on whether the LITC pro-vides assistance with a return of tax or claimfor refund under subtitle A, or if the LITCcharges more than a nominal fee for its ser-vices.

* * * * *


Internal Revenue.

Approved December 11, 2002.

Pamela F. Olson,Assistant Secretary of the Treasury

(Tax Policy).

(Filed by the Office of the Federal Register on December 17,2002, 8:45 a.m., and published in the issue of theFederal Register for December 18, 2002, 67 F.R. 77418)

2003–5 I.R.B. 368 February 3, 2003

Part III. Administrative, Procedural, and Miscellaneous

Section 45D.—New MarketsTax Credit

Notice 2003–9

PURPOSE

The purpose of this notice is to announcethat the Treasury Department and Inter-nal Revenue Service will amend § 1.45D–1T(c)(3)(ii) of the temporary Income TaxRegulations to extend a deadline relating tocertain equity investments made before thereceipt of a new markets tax credit alloca-tion from the Secretary under § 45D(f)(2)of the Internal Revenue Code.

BACKGROUND

Section 45D(a)(1) provides a new mar-kets tax credit on certain credit allowancedates described in § 45D(a)(3) with re-spect to a qualified equity investment in aqualified community development entity(CDE).

Section 45D(b)(1) provides that an in-vestment in a CDE is a qualified equity in-vestment only if, among other requirements,the CDE designates the investment as aqualified equity investment.

Section 45D(c)(1) provides that an en-tity is a CDE only if, among other require-ments, the entity is certified by the Secretaryas a CDE.

Section 45D(b)(2) provides that themaximum amount of equity investments is-sued by a CDE that may be designated bythe CDE as qualified equity investmentsshall not exceed the portion of the new mar-kets tax credit limitation set forth in§ 45D(f)(1) that is allocated to the CDE bythe Secretary under § 45D(f)(2).

Section 1.45D–1T(c)(3)(i) provides that,except as provided in § 1.45D–1T(c)(3)(ii),an equity investment in an entity is not eli-gible to be designated as a qualified eq-uity investment if it is made before theentity enters into an allocation agreementwith the Secretary. An “allocation agree-ment” is an agreement between the Secre-tary and a CDE relating to a new marketstax credit allocation under § 45D(f)(2).

Section 1.45D–1T(c)(3)(ii) provides that,notwithstanding § 1.45D–1T(c)(3)(i), an eq-uity investment in an entity is eligible to bedesignated as a qualified equity invest-ment if — (A) the equity investment is

made on or after April 20, 2001; (B) the en-tity in which the equity investment is madeis certified by the Secretary as a CDE un-der § 45D(c) before January 1, 2003; (C)the entity in which the equity investmentis made receives notification of the creditallocation (with the actual receipt of suchcredit allocation contingent upon subse-quently entering into an allocation agree-ment) from the Secretary before January 1,2003; and (D) the equity investment oth-erwise satisfies the requirements of § 45Dand § 1.45D–1T.

The Secretary of the Treasury Depart-ment has delegated certain administrativefunctions relating to the new markets taxcredit program to the Under Secretary (Do-mestic Finance), who in turn has delegatedthose functions to the Community Devel-opment Financial Institutions Fund (CDFIFund). The delegated administrative func-tions include CDE certifications and newmarkets tax credit allocations.

The CDFI Fund published a Notice ofAllocation Availability (NOAA) in the Fed-eral Register on June 11, 2002 (67 FR40112) covering, among other things, howan entity applies for an allocation under§ 45D(f)(2). The NOAA set a deadline forreceiving all allocation applications (elec-tronic and written) of no later than 5 p.m.ET on August 29, 2002.

DISCUSSION

The CDFI Fund will not complete newmarkets tax credit allocations before Janu-ary 1, 2003. Accordingly, the Treasury De-partment and Service intend to amend§ 1.45D–1T(c)(3)(ii) to provide that, not-withstanding § 1.45D–1T(c)(3)(i), an eq-uity investment in an entity is eligible to bedesignated as a qualified equity invest-ment under § 1.45D–1T(c)(1)(iii) if:

1. The equity investment is made on orafter April 20, 2001;

2. The designation of the equity invest-ment as a qualified equity investment ismade for a credit allocation received pur-suant to an allocation application submit-ted to the CDFI Fund no later than August29, 2002; and

3. The equity investment otherwise sat-isfies the requirements of § 45D and§ 1.45D–1T.

The temporary regulations will be re-vised to incorporate the guidance set forth

in this notice. The revision to the tempo-rary regulations reflecting this notice willbe effective for equity investments made onor after April 20, 2001.


The principal author of this notice is PaulHandleman of the Office of Associate ChiefCounsel (Passthroughs and Special Indus-tries). For further information regarding thisnotice, contact Mr. Handleman at (202)622–3040 (not a toll-free call).

Definition of Early RetirementBenefit and Retirement-TypeSubsidy

Notice 2003–10

I. PURPOSE

The Internal Revenue Service and theTreasury Department intend to proposeregulations that would provide guidance onbenefits that are treated as early retire-ment benefits and retirement-type subsi-dies for purposes of § 411(d)(6)(B) of theInternal Revenue Code. It is expected thatthe regulations would include guidance re-solving conflicting court decisions that ad-dress the extent to which payments that arecontingent on the occurrence of an unpre-dictable event, such as a plant shutdown,are protected under § 411(d)(6)(B). The Ser-vice and Treasury invite comments on pos-sible approaches before regulations areproposed.

II. BACKGROUND

Section 411(d)(6) generally provides thata plan is not treated as satisfying the re-quirements of § 411 if the accrued ben-efit of a participant is decreased by a planamendment. Under § 411(d)(6)(B), a planamendment that has the effect of eliminat-ing or reducing a retirement-type subsidy,with respect to benefits attributable to ser-vice before the amendment, is treated as re-ducing accrued benefits for any employeewho satisfies the pre-amendment condi-tions for the subsidy (either before or af-ter the amendment). In addition, a planamendment that has the effect of eliminat-ing an early retirement benefit or, except as

February 3, 2003 369 2003–5 I.R.B.

provided in regulations, an optional formof benefit is treated as reducing accruedbenefits. Further, Treas. Reg. § 1.411(d)–4,Q&A–1(d) specifies benefits that are an-cillary and thus not protected from reduc-tion or elimination under § 411(d)(6)(B).

Section 645(b) of the Economic Growthand Tax Reform Reconciliation Act of 2001(EGTRRA) amended § 411(d)(6)(B) to pro-vide for the Secretary of Treasury to is-sue regulations permitting the eliminationof benefits or subsidies that create signifi-cant burdens or complexities for the planand plan participants, and that affect therights of any participant in no more than ade minimis manner. In Notice 2002–46,2002–28 I.R.B. 96, the Service and Trea-sury requested comments in advance of de-veloping regulations implementing theEGTRRA amendment.

Section 204(g) of the Employee Retire-ment Income Security Act of 1974(ERISA), Public Law 93–406, 88 Stat. 829,as amended, provides parallel rules to therules of § 411(d)(6) of the Code. Pursu-ant to Reorganization Plan. No. 4 of 1978,43 F.R. 47713, October 17, 1978, 1979–1C.B. 480, Treasury regulations issued un-der § 411(d)(6) apply as well for purposesof § 204(g) of ERISA.

Section § 411(d)(6)(B) was added to theCode by § 301 of the Retirement Equity Actof 1984 (“REA”), Pub. L. No. 98–397, 98Stat. 1426, 1450–51 (1984). With respectto retirement-type subsidies, the legisla-tive history relating to § 301 of REA states,in part:

The bill provides that an amendment ofa qualified plan is to be treated as re-ducing accrued benefits if, with respectto benefits accrued before the amend-ment is adopted, the amendment has theeffect of either (1) eliminating or reduc-ing an early retirement benefit or aretirement-type subsidy, or (2) except asprovided by Treasury regulations, elimi-nating an optional form of benefit.

* * *The bill provides that the term“retirement-type subsidy” is to be de-fined by Treasury regulations. The com-mittee intends that under theseregulations, a subsidy that continues af-ter retirement is generally to be consid-ered a retirement-type subsidy. Thecommittee expects, however, that a quali-fied disability benefit, a medical ben-efit, a social security supplement, a death

benefit (including life insurance), or aplant shutdown benefit (that does notcontinue after retirement age) will notbe considered a retirement-type sub-sidy. The committee expects that Trea-sury regulations will prevent therecharacterization of retirement-type ben-efits as benefits that are not protected bythe provision.

S. Rep. No. 98–575, at 28, 30 (1984), re-printed in 1984 U.S.C.C.A.N. 2547, 2574,2576.

Questions have arisen as to whether abenefit that is contingent on the occur-rence of an unpredictable event, such as aplant shutdown or an involuntary separa-tion, is a retirement-type subsidy and, thus,protected by § 411(d)(6). Since the enact-ment of REA, three circuit courts have heldthat an unpredictable contingent event ben-efit is protected, while one has held that itis not. Compare Bellas v. CBS, Inc., 221F.3d 517 (3rd Cir. 2000), cert. denied, 531U.S. 1104 (2001) (separation benefit is bothan early retirement benefit and a retirement-type subsidy to the extent it provides for thepayment of normal retirement benefits thatcontinue beyond normal retirement age);Richardson v. Pension Plan of BethlehemSteel Corp., 67 F.3d 1462 (9th Cir. 1995),withdrawn, 91 F.3d 1312 (9th Cir. 1996),modified, 112 F.3d 982 (9th Cir. 1997)(shutdown benefit is a retirement-type sub-sidy protected under anticutback rule, opin-ion withdrawn and modified because courtlater found plan amendment not valid), andHarms v. Cavenham Forest Industries, Inc.,984 F.2d 686 (5th Cir.), cert. denied, 510U.S. 944 (1993) (involuntary separationbenefit is a retirement-type benefit pro-tected under the anticutback rule), with Rossv. Pension Plan for Hourly Employees ofSKF Industries, Inc., 847 F.2d 329 (6th Cir.1988) (plant shutdown benefit is not aretirement-type subsidy).

III. UPCOMING PROPOSEDREGULATIONS

The Service and Treasury anticipate thatupcoming proposed regulations will pro-vide general guidance concerning early re-tirement benefits and retirement-typesubsidies under § 411(d)(6)(B). The up-coming proposed regulations are expectedto address whether benefits that are con-tingent on the occurrence of certain events,such as plant shutdown or involuntary sepa-

ration, and that continue beyond normal re-tirement age, are retirement-type subsidiesthat are protected under § 411(d)(6)(B) bothbefore and after the occurrence of the con-tingency. In addition, the upcoming pro-posed regulations are expected to addressthe question of whether payment of the ac-crued benefit at an early commencementdate on an unreduced or partially subsi-dized basis will be treated as providing abenefit that continues beyond normal re-tirement age and, hence, would be consid-ered to be a retirement-type subsidy.

Section § 411(d)(6) does not restrict theability of an employer to amend a plan toeliminate accruals, subsidies, or other ben-efits (whether or not contingent), with re-spect to benefits not yet accrued. Thus, forexample, the anticipated proposed regula-tions would not restrict an employer fromamending a plan to compute the subsi-dized portion of the contingent benefit basedsolely on service completed before the dateof the amendment, or to limit the benefitpayable under the retirement-type sub-sidy to the amount payable as of the dateof the amendment. In addition, because§ 411(d)(6) does not prevent an employerfrom amending a plan to eliminate ancil-lary benefits, the anticipated proposed regu-lations would not restrict a plan amendmentto eliminate contingent benefits that are an-cillary benefits. Thus, the anticipated pro-posed regulations would not restrict a planamendment to eliminate an ancillary ben-efit described in Treas. Reg. § 1.411(d)–4,Q&A–1(d) (e.g., a social security supple-ment that is not a qualified social secu-rity supplement under § 1.401(a)(4)–12),regardless of whether the amendment oc-curs before or after the occurrence of anycontingency on which the benefit is based.

IV. REGULATIONS WILL BEPROSPECTIVE

The regulations described above will beprospective. Regardless of the position takenin the final regulations, the Service will nottreat a plan as failing to satisfy the require-ments of §§ 401 and 411 merely becauseof a plan amendment that eliminates or re-duces an early retirement benefit orretirement-type subsidy that is conditionedon the occurrence of an unpredictable con-tingent event (within the meaning of sec-tion § 412(l)) if the amendment is adoptedand effective prior to the occurrence of thecontingent event and prior to the publica-

2003–5 I.R.B. 370 February 3, 2003

tion of final regulations addressing this is-sue in the Federal Register. Note, however,that it is clear under current law that sucha plan amendment is prohibited under§ 411(d)(6) and § 411(a) (which providesvesting requirements for accrued benefitsand prohibits forfeiture of a vested ac-crued benefit) if the amendment is adoptedor effective after the occurrence of the con-tingent event.

V. COMMENTS REQUESTED

Comments regarding the anticipated pro-posed regulations described in this noticeare requested, including comments on theguidance that should be provided regard-ing early retirement benefits and retirement-type subsidies. In addition, comments arerequested on the extent to which such pro-posed regulations should include relief foramendments that eliminate or reduce earlyretirement benefits or retirement-type sub-sidies that are contingent on unpredict-able events, that create significant burdensor complexities for the plan and plan par-ticipants, and that affect the rights of anyparticipant in no more than a de minimismanner. Comments should be submitted byMay 5, 2003, to CC:ITA:RU (Notice 2003–10), Room 5226, Internal Revenue Ser-vice, POB 7604, Ben Franklin Station,Washington, D.C. 20044. Comments maybe hand delivered between the hours of 8a.m. and 5 p.m., Monday through Friday toCC:ITA:RU (Notice 2003–10), Courier’sDesk, Internal Revenue Service, 1111 Con-stitution Ave., NW, Washington D.C. Al-ternatively, comments may be submitted viathe Internet at [email protected]. All comments willbe available for public inspection.

VI. EFFECT ON OTHERDOCUMENTS

Notice 2002–46 is modified.


The principal authors of this notice arePreston Rutledge of the Office of the As-sociate Chief Counsel (Tax Exempt andGovernment Entities) and Diane S. Bloomof the Employee Plans, Tax Exempt andGovernment Entities Division. For fur-ther information regarding this notice, con-tact the Employee Plans taxpayer assistancetelephone service between the hours of 8:00a.m. and 6:30 p.m. Eastern Time, Mon-

day through Friday by calling 1–877–829–5500 (a toll-free number). Mr. Rutledge canbe reached at (202) 622–6090 andMs. Bloom can be reached at (202) 283–9888 (not toll-free numbers).

26 CFR 601.106: Appeals functions.(Also Part I, §§ 6015; 1.6015–6.)

Rev. Proc. 2003–19

SECTION 1. PURPOSE

This revenue procedure provides guid-ance on the administrative appeal rights ofa spouse or former spouse when a tax-payer seeks relief from federal income taxliability under section 6015 of the Inter-nal Revenue Code.

SECTION 2. BACKGROUND

.01 Section 6013(d)(3) provides that mar-ried taxpayers who file a joint return un-der section 6013 will be jointly andseverally liable for the tax arising from thatreturn. For purposes of section 6013(d)(3)and this revenue procedure, the term “tax”includes penalties, additions to tax, and in-terest. See sections 6665(a)(2) and6601(e)(1).

.02 Section 6015 provides relief in cer-tain circumstances from the joint and sev-eral liability imposed by section 6013(d)(3).For purposes of this revenue procedure, theindividual seeking relief from federal in-come tax liability under section 6015 is re-ferred to as a “requesting spouse” and theindividual with whom the requesting spousefiled the joint return is referred to as a “non-requesting spouse.”

.03 To request relief under section 6015,a requesting spouse must file a Form 8857,“Request for Innocent Spouse Relief,” ora written statement with the Internal Rev-enue Service signed under penalties of per-jury, containing the same informationrequired on Form 8857.

.04 Prior to publication of this revenueprocedure, only the requesting spouse hadthe right to file a written protest and re-ceive an administrative conference with theService’s Appeals Office (an “Appeals con-ference”). The Service has determined thatthe nonrequesting spouse may file a writ-ten protest and receive an Appeals confer-ence with respect to the Service’s decisionto grant partial or full relief to the request-

ing spouse. The nonrequesting spouse maynot, however, appeal a decision by the Ser-vice to deny relief to the requesting spouse.

.05 In section 6015(h)(2), Congress ex-pressed its intent that the nonrequestingspouse have notice of, and be involved in,proceedings with respect to a section 6015election made by the requesting spouse. Thenonrequesting spouse has (with respect tothe Service or the Tax Court, as the casemay be) the following opportunities to par-ticipate in the determination of whether therequesting spouse is entitled to relief un-der section 6015:

(1) As required by section 6015(h)(2)and section 1.6015–6 of the Income TaxRegulations, the Service notifies the non-requesting spouse of the requesting spouse’sclaim for relief and provides the nonre-questing spouse with an opportunity to sub-mit information to be considered by theService in its administrative determina-tion. The nonrequesting spouse is not re-quired to provide information. The Servicewill consider all relevant information sub-mitted by the requesting spouse and thenonrequesting spouse in determiningwhether to grant or deny relief.

(2) Once the Service notifies the re-questing spouse and the nonrequestingspouse of the preliminary determination re-garding the requesting spouse’s claim forrelief, the requesting spouse, the nonre-questing spouse, or both spouses may filea protest and receive an Appeals confer-ence as set forth in section 4 of this rev-enue procedure.

(3) Section 6015(e)(1)(A) allows the re-questing spouse to petition the Tax Courtfrom a notice of final determination. Thereare no provisions in section 6015 that al-low the nonrequesting spouse to petition theTax Court from a notice of final determi-nation. See Maier v. Commissioner, 119 T.C.267 (2002). If, however, the requestingspouse petitions the Tax Court, section6015(e)(4) and the Tax Court’s Rules al-low the nonrequesting spouse to become aparty to the proceeding.

SECTION 3. SCOPE

This revenue procedure applies to a non-requesting spouse who appeals the prelimi-nary determination granting full or partialrelief from joint and several liability to arequesting spouse.

February 3, 2003 371 2003–5 I.R.B.

SECTION 4. GENERALPROCEDURES

.01 Initial proceedings following a re-questing spouse’s claim for relief under sec-tion 6015. In general, the Service willfollow the procedures below after mak-ing a preliminary determination regard-ing a claim for relief from joint and severalliability:

(1) The Service will issue a prelimi-nary determination letter to the request-ing spouse based on the merits of the claim.In the event the preliminary determina-tion grants full or partial relief, the Ser-vice will suspend processing of the claimfor 45 calendar days, pending an appeal bythe nonrequesting spouse. The Service willnotify the requesting spouse that the non-requesting spouse has the right to sepa-rately protest the Service’s preliminarydetermination.

(2) The Service will notify the nonre-questing spouse of the preliminary deter-mination at the same time the Servicenotifies the requesting spouse. The nonre-questing spouse has the right to file a writ-ten protest and request an Appealsconference to protest the preliminary de-termination to grant partial or full relief. Tobe eligible for an Appeals conference, thenonrequesting spouse must request an Ap-peals conference, in writing, within 30 cal-endar days of the mailing date of thenotification letter. If the nonrequestingspouse appeals, the Service will suspendfurther processing of the requesting spouse’sclaim for relief pending the outcome of thenonrequesting spouse’s appeal.

.02 Procedures for cases forwarded toAppeals. The following procedures will ap-ply to Appeals conferences for section 6015claims for relief:

(1) If, after the Service issues a prelimi-nary determination letter to the request-ing spouse, only the nonrequesting spousefiles a written protest requesting an Ap-peals conference, the Service will notify therequesting spouse of the nonrequestingspouse’s request for an Appeals confer-ence. The Service will hold an Appeals con-ference with the nonrequesting spouse. IfAppeals proposes to change the prelimi-nary determination, the requesting spousewill have an opportunity to request an Ap-peals conference to present his or her po-sition including any relevant informationbefore the final determination.

(2) If, after the Service issues a prelimi-nary determination letter to the request-ing spouse, only the requesting spouse filesa written protest requesting an Appeals con-ference, the Service will notify the nonre-questing spouse of the requesting spouse’srequest for a conference. The Service willhold an Appeals conference with the re-questing spouse. If Appeals proposes to in-crease the relief recommended in thepreliminary determination letter, the non-requesting spouse will have an opportu-nity to request an Appeals conference topresent his or her position including any rel-evant information before the final deter-mination.

(3) If, after the Service issues a prelimi-nary determination letter to the request-ing spouse, both spouses file written protestsrequesting Appeals conferences, the Ser-vice will notify each spouse of the otherspouse’s request for an Appeals confer-

ence. The Service will hold separate Ap-peals conferences with each spouse, withboth spouses permitted to submit informa-tion. The Service, in its discretion, may holda joint Appeals conference instead of sepa-rate Appeals conferences.

(4) Appeals conferences may be con-ducted by telephone, correspondence, face-to-face meetings or by a combination ofthese methods.

.03 Procedures after Appeals has madea determination. Upon reaching a final de-cision, Appeals will:

(1) Issue the notice of final determina-tion to the requesting spouse, unless the re-questing spouse executes a waiver pursuantto section 6015(e)(5); and

(2) Notify the nonrequesting spouse ofthe final determination.

SECTION 5. EFFECTIVE DATE

This revenue procedure is effective forall claims for relief filed on or after April1, 2003. In addition, this revenue proce-dure applies to any claims for relief filedprior to April 1, 2003, for which no pre-liminary determination has been issued asof April 1, 2003.

SECTION 6. DRAFTINGINFORMATION

The principal author of this revenue pro-cedure is Jamie P. MacLean of the Officeof the Associate Chief Counsel, Proce-dure and Administration (AdministrativeProvisions and Judicial Practice Division).For further information regarding this rev-enue procedure, contact Elvira Bosco of Ap-peals at (212) 298–2272 (not a toll-free call)or a local Appeals office.

2003–5 I.R.B. 372 February 3, 2003

Part IV. Items of General Interest

Notice of ProposedRulemaking and Notice ofPublic Hearing

Guidance RegardingDeduction and Capitalizationof Expenditures

REG–125638–01


ACTION: Notice of proposed rulemak-ing and notice of public hearing.

SUMMARY: This document contains pro-posed regulations that explain how sec-tion 263(a) of the Internal Revenue Code(Code) applies to amounts paid to acquire,create, or enhance intangible assets. Thisdocument also contains proposed regula-tions under section 167 of the Code thatprovide safe harbor amortization for cer-tain intangible assets, and proposed regu-lations under section 446 of the Code thatexplain the manner in which taxpayers maydeduct debt issuance costs. Finally, thisdocument provides a notice of public hear-ing on these proposed regulations.

DATES: Written or electronic commentsmust be received by March 19, 2003. Re-quests to speak and outlines of topics to bediscussed at the public hearing scheduledfor April 22, 2003, must be received byApril 1, 2003.

ADDRESSES: Send submissions toCC:ITA:RU (REG–125638–01), room 5226,Internal Revenue Service, POB 7604, BenFranklin Station, Washington, DC 20044.Submissions may be hand-delivered Mon-day through Friday between the hours of8 a.m. and 4 p.m. to: CC:ITA:RU (REG–125638–01), Courier’s Desk, Internal Rev-enue Service, 1111 Constitution Avenue,NW, Washington, DC or sent electroni-cally via the IRS Internet site at:www.irs.gov/regs. The public hearing willbe held in the IRS Auditorium, InternalRevenue Building, 1111 Constitution Av-enue, NW, Washington, DC.

FOR FURTHER INFORMATIONCONTACT: Concerning the proposed regu-lations, Andrew J. Keyso, (202) 927–9397;concerning submissions of comments, the

hearing, and/or to be placed on the build-ing access list to attend the hearing, GuyTraynor, (202) 622–7180 (not toll-free num-bers).


Background

In recent years, much debate has fo-cused on the extent to which section 263(a)of the Code requires taxpayers to capital-ize amounts paid to acquire, create, or en-hance intangible assets. On January 24,2002, the IRS and Treasury Departmentpublished an advance notice of proposedrulemaking (ANPRM) in the Federal Reg-ister (67 FR 3461) announcing an inten-tion to provide guidance in this area. TheANPRM described and explained rules un-der consideration by the IRS and Trea-sury Department and invited publiccomment on these rules.

Explanation of Provisions

I. Introduction

The proposed regulations under sec-tion 263(a) of the Code set forth a gen-eral principle that requires capitalization ofcertain amounts paid to acquire, create, orenhance intangible assets. In addition, theproposed regulations identify specific in-tangible assets for which capitalization isrequired under the general principle. Theseidentified intangible assets are grouped intocategories in the proposed regulations basedon whether the intangible asset is acquiredfrom another party or created by the tax-payer.

The proposed regulations also providerules for determining the extent to whichtaxpayers must capitalize transaction coststhat facilitate the acquisition, creation, orenhancement of intangible assets or that fa-cilitate certain restructurings, reorganiza-tions, and transactions involving theacquisition of capital. These transaction costrules allow for the use of simplifying con-ventions intended to promote administra-bility and reduce the cost of compliancewith section 263(a). In addition, the pro-posed regulations under section 167 of theCode provide a safe harbor amortization pe-riod applicable to certain created intan-gible assets that do not have readilyascertainable useful lives and for which anamortization period is not otherwise pre-

scribed or prohibited by the Code, regula-tions, or other published guidance.

As a general rule, the proposed regula-tions are not intended to apply to a tax-payer’s intangible interest in land. Thus, theproposed regulations do not apply toamounts paid to acquire or create ease-ments, life estates, mineral interests, tim-ber rights, or other intangible interests inland. An exception is made for amountspaid to acquire, create, or enhance a leaseof real property. Several rules contained inthe proposed regulations address amountspaid to acquire, create, or enhance leasesof property, including leases of real prop-erty. The IRS and Treasury Department areconsidering future guidance addressing thetreatment of amounts paid to acquire, cre-ate, or enhance tangible assets. Appropri-ate rules relating to the treatment of interestsin land will be addressed in that future guid-ance.

II. General Principle of Capitalization

A. Overview

The proposed regulations require capi-talization of amounts paid to acquire, cre-ate, or enhance an intangible asset. For thispurpose, an intangible asset is defined as(1) any intangible that is acquired from an-other person in a purchase or similar trans-action (as described in paragraph (c) of theproposed regulations); (2) certain rights,privileges, or benefits that are created ororiginated by the taxpayer and identified inparagraph (d) of the proposed regulations;(3) a separate and distinct intangible as-set (as defined in paragraph (b)(3) of theproposed regulations); or (4) a future ben-efit that the IRS and Treasury Departmentidentify in subsequent published guidanceas an intangible asset for which capitali-zation is required. As discussed in Part Vof this preamble, the proposed regulationsalso require capitalization of transactioncosts that facilitate the acquisition, cre-ation, or enhancement of an intangible as-set or that facilitate a restructuring orreorganization of a business entity or atransaction involving the acquisition of capi-tal, such as a stock issuance, borrowing, orrecapitalization.

Through this definition of intangible as-set, the IRS and Treasury Department seekto provide certainty for taxpayers by iden-tifying specific categories of rights, privi-

February 3, 2003 373 2003–5 I.R.B.

leges, and benefits, the costs of which areappropriately capitalized. In determining thecategories of expenditures for which capi-talization is specifically required, the IRSand Treasury Department considered ex-penditures for which the courts have tra-ditionally required capitalization. Thesecategories will help promote consistent in-terpretation of section 263(a) by taxpay-ers and IRS field personnel.

B. Separate and distinct intangible asset

The proposed regulations define the termseparate and distinct intangible asset basedon factors traditionally used by the courtsto determine whether an expenditure servesto acquire, create, or enhance a separate anddistinct asset. Courts have considered (1)whether the expenditure creates a distinctand recognized property interest subject toprotection under state or federal law; (2)whether the expenditure creates anythingtransferrable or salable; and (3) whether theexpenditure creates anything with an as-certainable and measurable value in mon-ey’s worth. See, e.g., Commissioner v.Lincoln Savings & Loan Ass’n, 403 U.S.345, 355 (1971); Central Texas Savings &Loan Ass’n v. United States, 731 F.2d 1181,1184 (5th Cir. 1984); Colorado Springs Na-tional Bank v. United States, 505 F.2d 1185,1192 (10th Cir. 1974); Briarcliff CandyCorp. v. Commissioner, 475 F.2d 775, 784(2nd Cir. 1973).

The proposed regulations provide that thedetermination of whether an amount servesto acquire, create, or enhance a separate anddistinct intangible asset is made as of thetaxable year during which the amount ispaid, and not later using the benefit of hind-sight.

The IRS and Treasury Department notethat the separate and distinct asset stan-dard has not historically yielded the samelevel of controversy as the significant fu-ture benefit standard. Moreover, severalcommentators suggested that, if the pro-posed regulations adopt a general prin-ciple of capitalization, the separate anddistinct asset test is a workable principle inpractice.

C. Significant future benefits identified inpublished guidance

A fundamental purpose of section 263(a)is to prevent the distortion of taxable in-come through current deduction of expen-

ditures relating to the production of incomein future years. Thus, in determiningwhether an expenditure should be capital-ized, the Supreme Court has consideredwhether the expenditure produces a sig-nificant future benefit. INDOPCO, Inc. v.Commissioner, 503 U.S. 79 (1992). A “sig-nificant future benefit” standard, however,does not provide the certainty and claritynecessary for compliance with, and soundadministration of, the law. Consequently, theIRS and Treasury Department believe thatsimply restating the significant future ben-efit test, without more, would lead to con-tinued uncertainty on the part of taxpayersand continued controversy between tax-payers and the IRS. Accordingly, the IRSand Treasury Department have initially de-fined the exclusive scope of the signifi-cant future benefit test through the specificcategories of intangible assets for whichcapitalization is required in the proposedregulations. The future benefit standard un-derlies many of these categories.

The IRS and Treasury Department rec-ognize, however, that there may be expen-ditures that are not identified in thesecategories, but for which capitalization isnonetheless appropriate. For this reason, theproposed regulations require capitaliza-tion of non-listed expenditures if those ex-penditures serve to produce future benefitsthat the IRS and Treasury Department iden-tify in published guidance as significantenough to warrant capitalization. A deter-mination in published guidance that a par-ticular category of expenditure produces abenefit for which capitalization is appro-priate will apply prospectively, and will notapply to expenditures incurred prior to thepublication of such guidance.

For purposes of future guidance, the IRSand Treasury Department will determinewhether capitalization is appropriate for aparticular category of expenditures by tak-ing into account all relevant facts and cir-cumstances, including the probability,measurability, and size of the expected fu-ture benefit. Such published guidance mayprovide a safe harbor amortization periodfor any expenditure required to be capital-ized. If the published guidance does not pro-vide a safe harbor amortization period, theexpenditure may be eligible for the 15-year safe harbor amortization period de-scribed in Part VII.A. of this preamble.

The IRS and Treasury Department be-lieve that, by applying the significant fu-

ture benefit test in the manner describedabove, the proposed regulations will sub-stantially reduce the burden on both tax-payers and IRS field personnel ofdetermining whether an expenditure pro-duces significant future benefits for whichcapitalization is required. If an expendi-ture is not described in one of the catego-ries in the proposed regulations or insubsequent future guidance, taxpayers andIRS field personnel need not determinewhether that expenditure produces a sig-nificant future benefit. Upon finalization ofthe proposed regulations, the IRS expectsto identify and withdraw existing capitali-zation guidance that is susceptible to ap-plication inconsistent with these regulations.

III. Intangibles Acquired From Another

Paragraph (c) of the proposed regula-tions requires capitalization of amounts paidto another party to acquire an intangiblefrom that party in a purchase or similartransaction. This rule reflects well-settledlaw requiring capitalization of the pur-chase price (including sales taxes and simi-lar charges) paid to acquire property fromanother. The regulations provide examplesof intangibles that must be capitalized un-der this rule if the intangible is acquiredfrom another person. Many of the intan-gibles required to be capitalized by this ruleconstitute “amortizable section 197 intan-gibles” eligible for 15-year amortization un-der section 197(a).

The rule does not address the treatmentof any transaction costs the taxpayer mayincur to facilitate the acquisition of an in-tangible from another party. The treat-ment of transaction costs is described inparagraph (e) of the proposed regulations.So, for example, while this rule requirescapitalization of the amount paid to an-other party to acquire an intangible fromthat party, this rule does not describe thetreatment of the various ancillary costs suchas attorney fees and broker commissions in-curred to facilitate the acquisition.

In addition, the rule applies only to ac-quired intangibles, and not to created in-tangibles. For example, the rule requires ataxpayer to capitalize the amount paid toacquire a customer base from another per-son. However, the rule does not require ataxpayer to capitalize costs that it incurs tocreate its own customer base.

2003–5 I.R.B. 374 February 3, 2003

IV. Created Intangibles

Paragraph (d) of the proposed regula-tions requires taxpayers to capitalizeamounts paid to another party to create orenhance with that party certain identifiedintangibles discussed in Parts IV.A. throughIV.H. of this preamble. Examples are in-cluded to demonstrate the scope of theserules.

To reduce the administrative and com-pliance costs associated with capitalizingthese amounts, the proposed regulationsadopt a “12-month rule” applicable to mostcreated intangibles. Under this 12-monthrule, a taxpayer is not required to capital-ize amounts that provide benefits of a rela-tively brief duration. The 12-month rule isdiscussed in further detail in Part VI of thispreamble.

As in the case of acquired intangibles,the rules in paragraph (d) relating to cre-ated intangibles address the amounts paidfor the intangible itself, and not the re-lated transaction costs incurred to facili-tate the creation of the intangible. Thetreatment of transaction costs is describedin paragraph (e) of the proposed regula-tions.

A. Financial interests

The proposed regulations require tax-payers to capitalize amounts paid to an-other party to create or originate with thatparty certain financial interests. The finan-cial interests identified in the rule includeinterests in entities (e.g., corporations, part-nerships, trusts) and financial instruments(e.g, debt instruments, notional principalcontracts, options).

The 12-month rule does not apply toamounts paid to create or enhance a finan-cial interest described in this rule, regard-less of whether the amounts are alsodescribed in another part of paragraph (d)of the proposed regulations.

B. Prepaid expenses

In general, existing law requires capi-talization of prepaid expenses. See, e.g.,Commissioner v. Boylston Market Ass’n,131 F.2d 966 (1st Cir. 1942). The pro-posed regulations require capitalization ofamounts prepaid for benefits to be receivedin the future. The proposed regulationsmodify slightly the rule contained in theANPRM, which proposed capitalization of“amounts prepaid for goods, services, or

other benefits (such as insurance) to be re-ceived in the future.” The reference to“goods” in the ANPRM caused some read-ers to question whether the proposed ruleis intended to apply to the acquisition oftangible property. The rule is not intendedto apply to the acquisition of tangible prop-erty. The rule proposes capitalization of pre-paid expenses on the ground that theprepayment creates an intangible asset inthe form of a right; specifically, the rightto receive goods, services, or other ben-efits in the future. The IRS and TreasuryDepartment decided to eliminate furtherconfusion by modifying the rule to re-move the explicit reference to goods.

Further, the reference in the rule to “ben-efits to be received in the future” is not in-tended to imply a form of “significant futurebenefit” test applicable to any expendi-ture that can be expected to result in somefuture benefit. As demonstrated by ex-amples in the proposed regulations, the ruleis intended merely to require capitaliza-tion of prepaid expenses.

C. Amounts paid to obtain certainmemberships and privileges

The proposed regulations require tax-payers to capitalize amounts paid to an or-ganization to obtain or renew a membershipor privilege from that organization. The ruleclarifies that amounts paid to obtain a qual-ity certification of the taxpayer’s prod-ucts, services, or business processes are notwithin the scope of the rule. Thus, for ex-ample, the rule does not require capitali-zation of amounts paid to obtain benefitssuch as ISO 9000 certification or Under-writers’ Laboratories Listing.

D. Amounts paid to obtain certain rightsfrom a governmental agency

The proposed regulations require tax-payers to capitalize amounts paid to a gov-ernmental agency for a trademark, tradename, copyright, license, permit, franchise,or other similar right granted by that gov-ernmental agency. In general, this rule is di-rected at the initial fee paid to a governmentagency. Under the 12-month rule, taxpay-ers are not required to capitalize annual re-newal fees paid to the government agency.An example in the proposed regulationsdemonstrates this point.

These regulations do not affect the treat-ment of expenditures under other provi-sions of the Code. Accordingly, an amount

paid to a government agency to obtain apatent from that agency is not required tobe capitalized under this section if theamount is deductible under section 174.

E. Amounts paid to obtain or modifycontract rights

The proposed regulations require tax-payers to capitalize amounts (other than deminimis amounts) paid to another party toinduce that party to enter into, renew, or re-negotiate an agreement that produces cer-tain rights for the taxpayer. This rulerecognizes that some agreements producecontract rights that are reasonably certainto produce future benefits for the taxpayer,or for which courts have traditionally re-quired capitalization. For example, the rulerequires capitalization of amounts paid toenter into or renegotiate a lease contract ora contract providing the taxpayer the rightto acquire or provide services. The rule alsorequires capitalization of an amount paid toobtain a covenant not to compete. Recog-nizing that employment contracts often areentered into along with covenants not tocompete, the proposed regulations con-tain a rule similar to that in § 1.197–2(b)(9)of the regulations. An agreement for the per-formance of services does not have sub-stantially the same effect as a covenant notto compete and, accordingly, amounts paidfor personal services actually rendered arenot required to be capitalized under this rule.

On the other hand, the rule recognizesthat many agreements do not produce con-tract rights for which capitalization is ap-propriate. Thus, the rule does not requirea taxpayer to capitalize an amount thatmerely creates an expectation that a cus-tomer or supplier will maintain its busi-ness relationship with the taxpayer.

The rule contains a de minimis excep-tion under which inducements that do notexceed $5,000 are not required to be capi-talized. The IRS and Treasury Departmentrequest comments on whether a non-cashinducement is properly valued at the tax-payer’s cost to acquire or produce the in-ducement, or at the fair market value of theinducement. If the non-cash inducement isproperly valued at its fair market value,comments are requested regarding the treat-ment of any gain or loss realized on thetransfer of the non-cash inducement.

This rule and the financial interests rule(described in Part IV.A. of this preamble)are the exclusive capitalization provisions

February 3, 2003 375 2003–5 I.R.B.

for created contracts. In other words,amounts paid to enter into an agreement notidentified in these rules are not required tobe capitalized under the general principleof capitalization on the theory that theagreement is a separate and distinct intan-gible asset.

F. Amounts paid to terminate certaincontracts

The proposed regulations require tax-payers to capitalize an amount paid to ter-minate three types of contracts. The purposeof the rule is to require capitalization of ter-mination payments that enable the tax-payer to reacquire some valuable right it didnot possess immediately prior to the ter-mination. Thus, capitalization is required forpayments by a lessor to terminate a leaseagreement with a lessee. See PeerlessWeighing and Vending Machine Corp. v.Commissioner, 52 T.C. 850 (1969). Capi-talization also is required for payments bya taxpayer to terminate an agreement thatprovides another party the exclusive rightto acquire or use the taxpayer’s property orservices or to conduct the taxpayer’s busi-ness. See Rodeway Inns of America v. Com-missioner, 63 T.C. 414 (1974). Finally,capitalization is required for payments toterminate an agreement that prohibits thetaxpayer from competing with another orfrom acquiring property or services from acompetitor of another.

On the other hand, the rule does not re-quire capitalization in cases where the tax-payer, as a result of the termination, doesnot reacquire a right for which capitaliza-tion is appropriate. For example, the ruledoes not require a taxpayer to capitalize apayment to terminate a supply contract witha supplier, and does not require a lessee tocapitalize a payment to terminate a leaseagreement with a lessor. This also is con-sistent with existing law. See, e.g., StuartCo. v. Commissioner, 195 F.2d 176 (9th Cir.1952), aff’g 9 T.C.M. (CCH) 585 (1950);Olympia Harbor Lumber Co. v. Commis-sioner, 30 B.T.A. 114 (1934), aff’d, 79 F.2d394 (9th Cir. 1935); Denholm & McKay Co.v. Commissioner, 2 B.T.A. 444 (1925); Rev.Rul. 69–511, 1969–2 C.B. 24.

The proposed regulations modify, in sev-eral respects, the rule described in theANPRM. First, the proposed regulations ex-pand the rule to require capitalization of anamount paid to terminate a contract thatgrants another the exclusive right to ac-

quire or use the taxpayer’s property or ser-vices. Thus, a taxpayer must capitalizeamounts paid to terminate an exclusive li-cense to use the taxpayer’s property. Sec-ond, the proposed regulations remove thereference to a defined geographic area fromthe rule requiring capitalization of amountspaid to terminate an agreement that pro-vides another party the exclusive right toconduct the taxpayer’s business. The IRSand Treasury Department are concerned thatthis reference may lead to uncertainty re-garding whether the parties intended for aparticular right to be limited to a definedgeographic area, especially where the agree-ment is silent regarding geographic area.Third, as discussed above, the proposedregulations require a taxpayer to capital-ize an amount paid to another to termi-nate an agreement that prohibits thetaxpayer from competing with another.

G. Amounts paid to acquire, produce, orimprove real property owned by another

The proposed regulations require tax-payers to capitalize an amount paid to ac-quire real property that is relinquished toanother, or to produce or improve real prop-erty that is owned by another, if the realproperty is reasonably expected to pro-duce significant economic benefits for thetaxpayer. The purpose of this rule is to rec-ognize a long line of cases and rulings thatrequire capitalization where the taxpayerprovides property to another or improvesproperty of another with the expectation thatthe property will provide significant fu-ture benefits for the taxpayer. See D. Love-man & Son Export Corp. v. Commissioner,34 T.C. 776 (1960), aff’d 296 F.2d 732 (6thCir. 1961) (expenditures incurred by the tax-payer to pave a public road benefitted thetaxpayer’s business and were appropri-ately capitalized); Chicago and N.W. Rail-way Co. v. Commissioner, 39 B.T.A. 661(1939) (conveyance of land by a railroadto a city for highway purposes, the effectof which is of lasting benefit by way offlood protection, access to city streets, andreduced cost of crossing protection is a capi-tal expenditure); Kauai Terminal Ltd. v.Commissioner, 36 B.T.A. 893 (1937) (ex-penditures incurred by the taxpayer to con-struct a publicly owned breakwater for thepurpose of improving the taxpayer’s freightlighterage operation are capital expendi-tures); Rev. Rul. 69–229, 1969–1 C.B. 86(expenditures incurred by a railroad com-

pany for construction of a state-owned high-way bridge over its tracks create a long termbusiness benefit for the taxpayer and aretherefore capital expenditures); Rev. Rul.66–71, 1966–1 C.B. 44 (expenditures in-curred by the taxpayer for dredging todeepen the portion of a harbor alongside thetaxpayer’s pier leading to a navigable chan-nel are capital expenditures).

The proposed regulations limit the scopeof the rule to real property, and not to alltangible property as originally contem-plated by the ANPRM. Some courts haverequired capitalization on the ground thatan intangible asset is created where the tax-payer provides tangible personal propertyto another. See, e.g., Alabama Coca-ColaBottling Co. v. Commissioner, T.C. Memo.1969–123 (capitalization required for costsincurred by a wholesaler to provide signs,scoreboards, and clocks bearing its prod-uct logo to retail outlets; the expenditurecreated valuable benefits that would ben-efit the taxpayer beyond the taxable year).Nonetheless, the IRS and Treasury Depart-ment are reluctant to extend the rule to casesinvolving tangible personal property. In-clusion of personal property within thescope of the rule would require capitaliza-tion of many expenditures that are prop-erly deductible under current law, such asadvertising or business promotion costs.

The proposed regulations clarify that therule is not intended to apply where the tax-payer is selling the real property, is pro-viding the real property to another aspayment for some other property or ser-vice provided to the taxpayer, or is sell-ing services to produce or improve theproperty. The proposed regulations alsoclarify that the rule is not intended tochange the result in Rev. Rul. 2002–9,2002–10 I.R.B. 614, regarding the treat-ment of impact fees paid by a developer ofreal property. Rev. Rul. 2002–9 providesthat impact fees incurred by a taxpayer inconnection with the construction of realproperty are capitalized costs allocable tothe real property. The proposed regula-tions provide that these costs do not cre-ate an intangible asset for whichcapitalization is required by this rule. Simi-larly, the proposed regulations provide thatreal property turned over to a governmententity in connection with a real estate de-velopment project (dedicated improve-ments) also are outside the scope of thisrule. Such costs are allocable to the prop-

2003–5 I.R.B. 376 February 3, 2003

erty produced, as provided in section 263Aand the regulations thereunder.

For costs required to be capitalized un-der this rule, the proposed regulations un-der section 167 permit safe harboramortization ratably over a 25-year pe-riod. The IRS and Treasury Department didnot adopt the approach suggested by com-mentators of permitting amortization overthe recovery period prescribed for the prop-erty under section 168 as if the taxpayer hadactually owned the real property and usedit in its trade or business. The IRS and Trea-sury Department believe that such an ap-proach would raise difficult questionsregarding the appropriate class life or re-covery period to be applied. In addition,such an approach would not address thetreatment of property for which a class lifeor recovery period is not prescribed by sec-tion 168, such as vacant land. The 25-year safe harbor will eliminate theuncertainty that would otherwise exist ifamortization were permitted over the pe-riod of the expected future benefit. The IRSand Treasury Department invite commentson this safe harbor amortization provi-sion.

H. Amounts paid to defend or perfecttitle to intangible property

The proposed regulations require tax-payers to capitalize an amount paid to an-other party to defend or perfect title tointangible property where the other partychallenges the taxpayer’s title to the intan-gible property. This is consistent with ex-isting regulations under section 263(a) ofthe Code. See § 1.263(a)–2(c). The rule isnot intended to require capitalization ofamounts paid to protect the property againstinfringement and to recover profits anddamages as a result of an infringement. Asunder current law, these costs are gener-ally deductible. See, e.g., Urquhart v. Com-missioner, 215 F.2d 17 (3rd Cir. 1954)(expenditures made by a licensor of pat-ents to protect against infringement and torecover profits and damages were made toprotect, conserve, and maintain businessprofits, and not to defend or perfect title toproperty). Whether an amount is paid to de-fend or perfect title, on the one hand, or toprotect against infringement, on the other,is a factual matter.

V. Transaction Costs

A. In general

The proposed regulations provide a two-pronged rule that requires taxpayers to capi-talize transaction costs. The first prong ofthe rule requires capitalization of transac-tion costs that facilitate the taxpayer’s ac-quisition, creation, or enhancement of anintangible asset. The second prong of therule requires capitalization of transactioncosts that facilitate the taxpayer’s restruc-turing or reorganization of a business en-tity or facilitate a transaction involving theacquisition of capital, including a stock is-suance, borrowing, or recapitalization.

The first prong of the transaction costrule recognizes that capitalization is re-quired not only for the cost of an asset it-self, but for the ancillary expendituresincurred in acquiring, creating, or enhanc-ing the intangible asset. Woodward v. Com-missioner, 397 U.S. 572 (1970). Theproposed regulations require that taxpay-ers capitalize these transaction costs to thebasis of the intangible asset acquired, cre-ated, or enhanced.

The second prong of the transaction costrule recognizes that transaction costs thateffect a change in the taxpayer’s capitalstructure create betterments of a perma-nent or indefinite nature and are appropri-ately capitalized. See INDOPCO, Inc. v.Commissioner, 503 U.S. 79 (1992) (pro-fessional fees incurred by a target corpo-ration in a stock acquisition); GeneralBancshares Corp. v. Commissioner, 326F.2d 712 (8th Cir. 1964) (costs to issue astock dividend to shareholders); Mills Es-tate, Inc. v. Commissioner, 206 F.2d 244(2nd Cir. 1953) (professional fees incurredin a recapitalization). As discussed in fur-ther detail in Part VII of this preamble (re-lating to safe harbor amortization), theproposed regulations do not address whetherthese costs increase the taxpayer’s basis inproperty or are treated as a separate intan-gible asset. Comments are requested onthese issues. However, in the case of trans-action costs that facilitate a stock issu-ance or recapitalization, the proposedregulations are consistent with existing law,which provides that such capital expendi-tures do not create a separate intangible as-set, but instead offset the proceeds of thestock issuance. See Rev. Rul. 69–330,1969–1 C.B. 51; Affiliated Capital Corp.v. Commissioner, 88 T.C. 1157 (1987). The

proposed regulations provide that capitali-zation is not required under this provi-sion for stock issuance costs of open-endregulated investment companies (other thanthose costs incurred during the initial stockoffering period). See Rev. Rul. 94–70,1994–2 C.B. 17.

As discussed in Part VII of this pre-amble, costs required to be capitalized un-der the second prong of the transaction costrule are not eligible for the safe harbor am-ortization provision provided in the regu-lations. However, comments are requestedon whether the safe harbor amortization pro-vision should apply to any of these costs.

The term reorganization as used in thesecond prong of the transaction cost rulecontemplates a reorganization in the broadsense of a change to an entity’s capitalstructure, and not merely a transaction thatconstitutes a tax-free reorganization un-der the Code. The terms reorganization andrestructuring are broad enough to includetransactions under section 351 of the Code,as well as bankruptcy reorganizations. Whilethe term is broad enough to encompassstock redemptions, the treatment of costs in-curred in connection with a stock redemp-tion is specifically prescribed by section162(k). The terms reorganization and re-structuring are not intended to refer to merechanges in an entity’s business processes,commonly referred to as “re-engineering.”Thus, a taxpayer’s change from a batch in-ventory processing system to a “just-in-time” inventory processing system,regardless of whether the taxpayer refers tosuch change as a business “restructuring,”is not within the scope of the rule, as dem-onstrated by example in the proposed regu-lations.

Consistent with existing law, the rule re-quires capitalization of costs to facilitate adivisive transaction. See Bilar Tool & DieCorp. v. Commissioner, 530 F.2d 708 (6thCir. 1976). However, the rule does not re-quire capitalization of amounts paid to fa-cilitate a divisive transaction where thedivestiture is pursuant to a government man-date, unless the divestiture is a condition ofpermitting the taxpayer to participate in aseparate restructuring or reorganizationtransaction. See, e.g., El Paso Co. v. UnitedStates, 694 F.2d 703 (Fed Cir. 1982); Ameri-can Stores Co. v. Commissioner, 114 T.C.458 (2000).

In the ANPRM, the second prong of thetransaction cost rule applied to “an appli-

February 3, 2003 377 2003–5 I.R.B.

cable asset acquisition within the mean-ing of section 1060(c).” This languagecaused confusion as to whether the sec-ond prong of the transaction cost rule ap-plied to acquisitions of tangible assets. Toclarify that the transaction cost rules do notapply to acquisitions of tangible assets(other than acquisitions of real property de-scribed in Part IV.G. of this preamble) theproposed regulations delete the reference tosection 1060(c). To the extent that intan-gible assets are acquired in an applicableasset acquisition under section 1060(c), thefirst prong of the transaction cost rule re-quires capitalization of transaction costs thatfacilitate the acquisition of those intan-gible assets. Transaction costs allocable totangible assets are capitalized to the ex-tent provided by existing law. The IRS andTreasury Department are considering sepa-rate guidance to address the treatment of ex-penditures to acquire, create, or enhancetangible assets.

B. Facilitate

The proposed regulations provide a “fa-cilitate” standard for purposes of determin-ing whether transaction costs must becapitalized. The facilitate standard is in-tended to be narrower in scope than a “but-for” standard. Thus, some transaction coststhat arguably are capital under a but-forstandard, such as costs to downsize a work-force after a corporate merger (includingseverance payments) or costs to integratethe operations of merged businesses, are notrequired to be capitalized under a facili-tate standard. While such costs may nothave been incurred but-for the merger, thecosts do not facilitate the merger itself. Theproposed regulations provide that an amountfacilitates a transaction if it is incurred inthe process of pursuing the acquisition, cre-ation, or enhancement of an intangible as-set or in the process of pursuing arestructuring, reorganization, or transac-tion involving the acquisition of capital.

In response to the ANPRM, commen-tators suggested that the proposed regula-tions should distinguish costs to facilitatethe acquisition of a trade or business fromcosts to investigate the acquisition of a tradeor business. Several commentators sug-gested that the proposed regulations shouldadopt the standard contained in Rev. Rul.99–23, 1999–1 C.B. 998.

Rev. Rul. 99–23 provides a “whether-and-which” test for distinguishing costs toinvestigate the acquisition of a new tradeor business (which are amortizable undersection 195) from costs to facilitate the ac-quisition (which are capital expenditures un-der section 263(a) and are not amortizableunder section 195). Under this test, costsincurred to determine whether to acquire anew trade or business, and which new tradeor business to acquire, are investigatorycosts. Costs incurred in the attempt to ac-quire a specific business are costs to fa-cilitate the consummation of the acquisition.

Because Rev. Rul. 99–23 has createdcontroversy between taxpayers and the IRS,the proposed regulations do not adopt thestandard contained in Rev. Rul. 99–23.Rather, the proposed regulations provide,as a bright line rule, that an amount paidin the process of pursuing an acquisition ofa trade or business (whether the acquisi-tion is structured as an acquisition of stockor of assets and whether the taxpayer is theacquirer in the acquisition or the target ofthe acquisition) is required to be capital-ized only if the amount is “inherently fa-cilitative” or if the amount relates toactivities performed after the earlier of thedate a letter of intent (or similar commu-nication) is issued or the date the taxpay-er’s Board of Directors approves theacquisition proposal. For this purpose, theproposed regulations identify amounts thatare inherently facilitative (e.g., amounts re-lating to determining the value of the tar-get, drafting transactional documents, orconveying property between the parties).Under this bright line rule, an amount thatdoes not facilitate the acquisition is not re-quired to be capitalized under this sec-tion. The proposed regulations do not affectthe treatment of start-up expenditures un-der section 195. The IRS and Treasury De-partment are considering the application ofthese bright line standards to tangible as-sets acquired as part of a trade or busi-ness in order to provide a singleadministrable standard in these transac-tions. The IRS and Treasury Department re-quest comments on whether the bright linestandard provided in the proposed regula-tions is administrable and whether there areother bright line standards that can be ap-plied in this area.

The proposed regulations provide that asuccess-based fee is an amount paid to fa-

cilitate the acquisition except to the ex-tent that evidence clearly demonstrates thatsome portion of the amount is allocable toactivities that do not facilitate the acquisi-tion. The IRS and Treasury Department re-quest comments on the treatment of success-based fees.

The IRS and Treasury Department stressthat section 6001 of the Code requires tax-payers to maintain sufficient records to sup-port a position claimed on the taxpayer’sreturn. Thus, taxpayers must maintainrecords adequate to document that amountsrelate to activities performed prior to thebright line date. Comments are requestedon the types of records that are availablein the context of an acquisition of a tradeor business and how these records might beutilized to administer the bright line rule.

C. Hostile takeover defense costs

The proposed regulations provide thattransaction costs incurred by a taxpayer todefend against a hostile takeover of the tax-payer’s stock do not facilitate the acquisi-tion and therefore are not required to becapitalized. See A.E. Staley Mfg. Co. v.Commissioner, 119 F.3d 482 (7th Cir. 1997).The proposed regulations recognize, how-ever, that an initially hostile acquisition at-tempt may eventually become friendly. Insuch a case, the rules require the taxpayerto bifurcate its costs between those in-curred to defend against the acquisition at-tempt at the time the attempt was hostileand those incurred to facilitate the friendlyacquisition. Capitalization is required forcosts incurred to facilitate the friendly ac-quisition. The IRS and Treasury Depart-ment request comments on rules that mightbe applied to determine the point at whicha hostile acquisition attempt becomesfriendly.

Some costs may be viewed both as coststo defend against a hostile acquisition andas costs to facilitate another capital trans-action. For example, a taxpayer may at-tempt to thwart a hostile acquisition bymerging with a white knight, recapitaliz-ing, or issuing stock purchase rights to ex-isting shareholders. The proposedregulations require capitalization of suchcosts, regardless of whether the taxpay-er’s purpose in incurring such costs wassolely to defend against a hostile acquisi-tion.

2003–5 I.R.B. 378 February 3, 2003

D. Simplifying conventions applicable totransaction costs

1. Salaries and Overhead

Much of the recent debate surround-ing section 263(a) has focused on the ex-tent to which capitalization is required foremployee compensation and overhead coststhat are related to the acquisition, creation,or enhancement of an asset. Generally,courts and the Service have required capi-talization of such costs where the facts showthat the costs clearly are allocable to a par-ticular asset. See Commissioner v. IdahoPower Co., 418 U.S. 1 (1973) (requiringcapitalization of depreciation on equip-ment used to construct capital assets andnoting that wages, when paid in connec-tion with the construction or acquisition ofa capital asset, must be capitalized and am-ortized over the life of the capital asset);Louisville and N.R. Co. v. Commissioner,641 F.2d 435 (6th Cir. 1981) (requiringcapitalization of overhead costs associ-ated with building and rebuilding railroadfreight cars); Lychuk v. Commissioner, 116T.C. 374 (2001) (requiring capitalization ofemployee compensation where employ-ees spent a significant portion of their timeworking on acquisitions of installment ob-ligations); Rev. Rul. 73–580, 1973–2 C.B.86 (requiring capitalization of employeecompensation reasonably attributable to ser-vices performed in connection with corpo-rate mergers and acquisitions).

In the context of intangible assets, somecourts have allowed taxpayers to deduct em-ployee compensation and overhead wherethere is only an indirect nexus between theintangible asset and the compensation oroverhead. See Wells Fargo v. Commis-sioner, 224 F.3d 874 (8th Cir. 2000) (de-duction allowed for officers’ salariesallocable to work performed by corporateofficers in negotiating a merger transac-tion because the salaries “originated fromthe employment relationship between thetaxpayer and its officers” and not from themerger transaction); PNC Bancorp v. Com-missioner, 212 F.3d 822 (3rd Cir. 2000) (de-duction allowed for compensation and othercosts of originating loans to borrowers); Ly-chuk v. Commissioner, 116 T.C. 374 (2001)(capitalization not required for overheadcosts allocable to the taxpayer’s acquisi-tion of installment loans because the over-head did not originate in the process ofacquiring the installment notes, and would

have been incurred even if the taxpayer didnot engage in such acquisition).

To resolve much of this controversy, andto eliminate the burden on taxpayers of al-locating certain transaction costs amongvarious intangible assets, the proposed regu-lations provide a simplifying assumptionthat employee compensation and over-head costs do not facilitate the acquisi-tion, creation or enhancement of anintangible asset. The rule applies regard-less of the percentage of the employee’stime that is allocable to capital transac-tions. For example, capitalization is not re-quired for compensation paid to anemployee of the taxpayer who works fulltime on merger transactions.

The proposed regulations modify the ruleproposed in the ANPRM by extending thescope of the rule to all employee compen-sation, whether paid in the form of sal-ary, bonus, or commission. Commentatorsnoted that bonuses are rarely paid with re-spect to one particular transaction, and a re-quirement to capitalize bonuses would notresult in simplification given the neces-sity of allocating bonuses among capitaltransactions. In the case of overhead, theproposed regulations modify the rule pro-posed in the ANPRM by extending thescope of the rule to variable overhead. TheIRS and Treasury Department have con-cluded that the clearer reflection of in-come that might be gained by requiringcapitalization of employee compensationand overhead does not offset the adminis-trative and record keeping burdens im-posed by a capitalization requirement.

These simplifying conventions are in-tended to be rules of administrative con-venience, and not substantive rules of law.Accordingly, in the case of employee com-pensation and overhead, the IRS and Trea-sury Department are considering limiting theapplication of the simplifying conventionsto taxpayers that deduct these costs for fi-nancial accounting purposes. Under this ap-proach, the simplifying conventions foremployee compensation and overheadwould not apply to taxpayers that capital-ize these costs for financial accounting pur-poses. A book-tax conformity rule wouldrecognize that there is no simplificationgained by allowing a deduction for em-ployee compensation and overhead wherethe taxpayer allocates these costs to intan-gible assets and capitalizes them for finan-cial accounting purposes. The IRS and

Treasury Department anticipate that anysuch book-tax conformity rule would notapply to de minimis costs.

The proposed regulations do not pres-ently include a book-tax conformity rule.However, the IRS and Treasury Depart-ment request comments on whether the fi-nal regulations should apply a book-taxconformity rule to employee compensa-tion and overhead.

2. De Minimis Costs

The proposed regulations provide that deminimis transaction costs do not facilitatea capital transaction and therefore are notrequired to be capitalized. The rule de-fines de minimis costs as costs that do notexceed $5,000. The IRS and Treasury De-partment considered whether the de mini-mis rule should be based on the taxpayer’sgross receipts, total assets, or some othervariable benchmark, rather than a fixedamount. The IRS and Treasury Depart-ment decided not to adopt such an ap-proach because of concern that it would addcomplexity and create administrability is-sues, particularly where the benchmarkamount changes as a result of amended re-turns or audit adjustments.

The proposed regulations clarify that thede minimis rule applies on a transaction-by-transaction basis. As demonstrated by ex-amples in the proposed regulations, a singletransaction may involve the acquisition ofmultiple intangible assets. The proposedregulations also clarify that if transactioncosts (other than compensation and over-head) exceed $5,000, no portion of the costsis considered de minimis under the rule.Thus, all of the costs (not just the cost inexcess of $5,000) must be capitalized. TheIRS and Treasury Department request com-ments on whether additional rules are re-quired to prevent taxpayers from improperlyfragmenting agreements or transactions totake advantage of the de minimis rules con-tained in the proposed regulations.

The proposed regulations contain rulesfor aggregating costs allocable to a trans-action. While taxpayers generally must ac-count for the actual costs allocable to eachtransaction, the proposed regulations per-mit taxpayers to determine the applicabil-ity of the de minimis rules by computingthe average transaction cost for a pool ofsimilar transactions. The IRS and Trea-sury Department recognize that this aver-age cost pooling method could result in a

February 3, 2003 379 2003–5 I.R.B.

skewed average cost where several unusu-ally large transactions occur during the yearand request comments on how to addresssuch transactions. If the final regulations ul-timately provide this pooling mechanism forcomputing average transaction costs, tax-payers are reminded of their obligations un-der section 6001 of the Code to maintainsuch records as are sufficient to establishthe amount of any deductions claimed asde minimis costs.

The proposed regulations provide that thede minimis rule does not apply to commis-sions paid to acquire or create certain fi-nancial interests. Accordingly, taxpayersmust capitalize such commissions. The IRSand Treasury Department note that the treat-ment of commissions is well-settled un-der existing law. See Helvering v. Winmill,305 U.S. 79 (1938); § 1.263(a)–2(e). In ad-dition, because commissions generally aretraceable to a particular acquisition or cre-ation, no simplification is gained by treat-ing commissions as de minimis costs.

3. Regular and Recurring Costs

The ANPRM requested public com-ment on whether the recurring or nonre-curring nature of a transaction is anappropriate consideration in determiningwhether an expenditure incurred to facili-tate a transaction must be capitalized un-der section 263(a) and, if so, what criteriashould be applied in distinguishing be-tween recurring and nonrecurring transac-tions. The IRS and Treasury Departmentconsidered the public comments and con-cluded that a regular and recurring rulewould likely be too vague to be adminis-trable. The IRS and Treasury Departmentbelieve that the simplifying conventions foremployee compensation, overhead, and deminimis costs address the types of regularand recurring costs that are most appropri-ately excluded from capitalization. Thus, aregular and recurring rule is not providedin the proposed regulations.

VI. 12-Month Rule

A. In general

The existing regulations under sections263(a), 446, and 461 require taxpayers tocapitalize expenditures that create an as-set having a useful life substantially be-yond the close of the taxable year. See§§ 1.263(a)–2(a), 1.446–1(c)(1)(ii), and1.461–1(a)(2)(i). In determining whether an

asset has a useful life substantially be-yond the close of the taxable year, somecourts have adopted a “one-year” rule. U.S.Freightways Corp. v. Commissioner, 270F.3d 1137 (7th Cir. 2001), rev’g 113 T.C.329 (1999); Zaninovich v. Commissioner,616 F.2d 429 (9th Cir. 1980). Under thisrule, an expenditure may be deducted in theyear it is incurred, as long as the benefit re-sulting from the expenditure does not havea useful life that extends beyond one year.

The IRS and Treasury Department thinkthat a “12-month” rule would help to re-duce the administrative and compliancecosts inherent in applying section 263(a) toamounts paid to create or enhance intan-gible assets. Accordingly, under the pro-posed regulations, certain amounts(including transaction costs) paid to cre-ate or enhance intangible rights or ben-efits for the taxpayer that do not extendbeyond the period prescribed by the 12-month rule are treated as having a usefullife that does not extend substantially be-yond the close of the taxable year. Thus,such amounts are not required to be capi-talized under the proposed regulations.Amounts paid to create rights or benefitsthat do extend beyond the period prescribedby the 12-month rule must be capitalizedin full; no portion of these amounts is con-sidered to come within the scope of the 12-month rule on the ground that such portionis allocable to rights or benefits that will ex-pire within the period prescribed by the 12-month rule.

The 12-month rule does not apply toamounts paid to create or enhance finan-cial interests or to amounts paid to createor enhance self-created amortizable sec-tion 197 intangibles (as described in sec-tion 197(c)(2)(A)). Application of the 12-month rule to self-created amortizablesection 197 intangibles, but not to amor-tizable section 197 intangibles acquired fromanother person, would result in inconsis-tent treatment of amortizable section 197intangibles. The IRS and Treasury Depart-ment are reluctant to treat acquired amor-tizable section 197 intangibles different fromself-created amortizable section 197 intan-gibles.

The proposed regulations clarify the in-teraction of the 12-month rule with the eco-nomic performance rules contained insection 461(h) of the Code. Nothing in theseproposed regulations is intended to changethe application of section 461 of the Code,

including the application of the economicperformance rules. In the case of a tax-payer using the accrual method of account-ing, section 461 requires that an item beincurred before it is taken into accountthrough capitalization or deduction. For ex-ample, under the economic performancerules, amounts prepaid for goods or ser-vices generally are not incurred, and there-fore may not be taken into account by anaccrual method taxpayer, until such time asthe goods or services are provided to thetaxpayer (subject to the recurring item ex-ception). § 1.461–4(d)(2)(i). Thus, the 12-month rule provided by the regulations doesnot permit an accrual method taxpayer todeduct an amount prepaid for goods or ser-vices where the amount has not been in-curred under section 461 (for example,where the taxpayer can not reasonably ex-pect that it will be provided goods or ser-vices within 31⁄2 months after the date ofpayment). The proposed regulations con-tain examples demonstrating the interac-tion of the 12-month rule with the economicperformance rules of section 461(h).

B. Application of 12-month rule tocontract terminations

The proposed regulations clarify that, forpurposes of applying the 12-month rule, anamount paid to terminate a contract de-scribed in Part IV.F. of this preamble priorto its expiration date creates a benefit forthe taxpayer equal to the unexpired term ofthe agreement as of the date of termina-tion. Thus, for example, if a lessor incurscosts to terminate a lease with an unex-pired term of 10 months, the 12-month rulewill apply to those costs.

C. Rights of indefinite duration

The 12-month rule does not apply tocontracts or other rights that have an in-definite duration. Rights of indefinite du-ration include rights that have no period ofduration fixed by agreement or law or thatare not based on a period of time, but arebased on a right to provide or receive afixed amount of goods or services. The IRSand Treasury Department believe that, inmany cases, application of the 12-monthrule to contracts or other rights that are notbased on a period of time would necessi-tate speculation regarding whether the con-tract or other right could reasonably beexpected to be completed within 12 months.In addition, the IRS and Treasury Depart-

2003–5 I.R.B. 380 February 3, 2003

ment believe that amounts paid to create orenhance such rights should be capitalizedand recovered through amortization, througha loss deduction upon abandonment of theright, or through basis recovery upon sale.

Further, § 1.167(a)–14(c) of the regula-tions provides rules for amortizing costs toobtain a right to receive a fixed amount ofproperty or services. Under these rules, thebasis of such right is amortized for each tax-able year by multiplying the basis of theright by a fraction, the numerator of whichis the amount of tangible property or ser-vices received during the taxable year andthe denominator of which is the totalamount of tangible property or services re-ceived or to be received under the terms ofthe contract. The IRS and Treasury De-partment believe that these amortizationrules provide a reasonable recovery methodfor many rights that are required to be capi-talized under these regulations, and serveas a sufficient substitute for a 12-month rule.

D. Rights that are renewable

The proposed regulations provide rulesfor determining whether renewal periodsshould be taken into account in determin-ing the treatment of a renewable contractwith an initial term that falls within thescope of the 12-month rule. The proposedregulations provide that renewal periods areto be taken into account if there is a “rea-sonable expectancy of renewal.” Some com-mentators suggested that renewals shouldbe taken into account only if renewal is“substantially likely” or “economically com-pelled.” The IRS and Treasury Depart-ment believe that the reasonable expectancyof renewal test is a more appropriate stan-dard, and note that this standard is consis-tent with the standard provided in§ 1.167(a)–14(c)(3) of the regulations forpurposes of determining the amortizationperiod for certain contract rights.

Whether a reasonable expectancy of re-newal exists depends on all relevant factsand circumstances in existence at the timethe contract or other right is created. Thefact that a particular contract is ultimatelyrenewed is not relevant in determiningwhether a reasonable expectancy of re-newal exists at the time the parties en-tered into the contract. The proposedregulations provide factors that are signifi-cant in determining whether a reasonableexpectancy of renewal exists.

The IRS and Treasury Department areconsidering rules that permit taxpayers whocreate, renew, or enhance a certain mini-mum number of similar rights or benefitsduring a taxable year to pool those trans-actions for purposes of applying the 12-month rule. The proposed regulationsprovide a broad outline of one poolingmethod under consideration by the IRS andTreasury Department. This method allowstaxpayers to apply the reasonable expect-ancy of renewal test to pools of similarrights or benefits. Under this proposedmethod, taxpayers are required to capital-ize an expenditure to obtain a right or ben-efit by reference to the reasonableexpectancy of renewal for the pool. Theproposed regulations provide that, if lessthan 20 percent of the rights or benefits inthe pool are reasonably expected to be re-newed, the taxpayer need not capitalize anycosts for the rights or benefits in the pool.On the other hand, if more than 80 per-cent of the rights or benefits in the pool arereasonably expected to be renewed, the tax-payer must capitalize all costs (other thande minimis costs described in Parts IV.E.and V.D.2. of this preamble) for the rightsor benefits in the pool. If 20 percent ormore but 80 percent or less of the rights orbenefits in the pool are reasonably ex-pected to be renewed, the taxpayer mustcapitalize a percentage of costs correspond-ing to the percentage of rights or benefitsin the pool that are reasonably expected tobe renewed. The proposed regulations pro-vide that taxpayers may define a pool ofsimilar contracts for this purpose using anyreasonable method. A reasonable methodwould include a definition of a pool basedon the type of customer and the type ofproperty or service provided.

The IRS and Treasury Department stressthat the pooling methods outlined in theseproposed regulations are not effective un-less these pooling methods are ultimatelypromulgated in final regulations. Accord-ingly, these proposed regulations do not pro-vide authority for taxpayers to adopt thepooling methods outlined herein. Publiccomments are requested regarding the fol-lowing specific issues related to pooling(both with respect to pools established forpurposes of applying the 12-month rule andwith respect to pools established for pur-poses of applying the de minimis rules):

(a) Would pooling be a useful simpli-fication measure for taxpayers?

(b) Should a pooling method be pro-vided in final regulations, or are rules gov-erning pooling more appropriately issued inthe form of industry-specific guidance orother non-regulatory guidance (e.g., rev-enue procedure)?

(c) Should a pooling method be treatedas a method of accounting under section446?

(d) Should the regulations define whatconstitutes “similar” contract rights or otherrights for purposes of defining a pool? Ifso, what factors should be considered in de-termining whether rights are similar?

(e) Should the regulations require the useof the same pools for depreciation pur-poses as are used for purposes of deter-mining the amount capitalized under theregulations? Is additional guidance neces-sary to clarify the interaction of the pool-ing rules with the rules in section 167 and§ 1.167(a)–8?

(f) The IRS and Treasury Departmentintend to require a minimum number ofsimilar transactions that a taxpayer must en-gage in during a taxable year in order to beeligible to apply the pooling method. Com-ments are requested regarding what thisminimum number of similar transactionsshould be.

VII. Safe Harbor Amortization

A. In general

The proposed regulations amend§ 1.167(a)–3 to provide a 15-year safe har-bor amortization period for certain cre-ated or enhanced intangibles that do nothave readily ascertainable useful lives. Forexample, amounts paid to obtain certainmemberships or privileges of indefinite du-ration would be eligible for the safe har-bor amortization provision. Under the safeharbor, amortization is determined using astraight-line method with no salvage value.

The prescribed 15-year period is con-sistent with the amortization period pre-scribed by section 197. Many commentatorssuggested that any safe harbor amortiza-tion period should be no longer than 60months, and noted that a 60-month amor-tization period is consistent with amorti-zation periods prescribed by sections 195(start up expenditures), 248 (organizationalexpenditures), and 709 (partnership orga-nization and syndication fees) of the Code.The IRS and Treasury Department are con-cerned that an amortization period shorterthan 15 years would create tension with sec-

February 3, 2003 381 2003–5 I.R.B.

tion 197, and might encourage attempts tocircumvent the provisions of section 197.

The safe harbor amortization period doesnot apply to intangibles acquired from an-other party or to created financial inter-ests. These intangibles are generally notamortizable, are amortizable under sec-tion 197, or are amortizable over a periodprescribed by other provisions of the Codeor regulations.

The safe harbor amortization period alsodoes not apply to created intangibles thathave readily ascertainable useful lives onwhich amortization can be based. Exist-ing law permits taxpayers to amortize in-tangible assets with reasonably estimableuseful lives. § 1.167(a)–3. For instance, pre-paid expenses, contracts with a fixed du-ration, and certain contract terminationshave readily ascertainable useful lives onwhich amortization can be based. Prepaidexpenses are amortized over the period cov-ered by the prepayment. Amounts paid toinduce another to enter into a contract witha fixed duration are amortized over the du-ration of the contract. Amounts paid by alessor to terminate a lease contract are am-ortized over the remaining term of the lease.Peerless Weighing and Vending MachineCorp. v. Commissioner, 52 T.C. 850, 852(1969).

The safe harbor amortization period doesnot overrule existing amortization peri-ods prescribed or prohibited by the Code,regulations, or other guidance. See, e.g., sec-tion 167(f)(1)(A) (prescribing a 36-monthlife for certain computer software); 171(prescribing rules for determining the am-ortization period for bond premium); 178(prescribing the amortization period for coststo acquire a lease); 197 (prescribing a 15-year life for certain intangible assets);§ 1.167(a)–14(d)(1) (prescribing a 108-month useful life for mortgage servicingrights).

Finally, the 15-year safe harbor does notapply to amounts paid in connection withreal property owned by another. As dis-cussed in Part IV.G. of this preamble, theproposed regulations provide a 25-year safeharbor amortization period for thoseamounts.

B. Restructurings, reorganizations andtransactions involving the acquisition ofcapital

The proposed regulations do not pro-vide safe harbor amortization for capital-

ized transaction costs that facilitate a stockissuance or other transaction involving theacquisition of capital. The regulations main-tain the historical treatment of stock issu-ance costs and costs that facilitate arecapitalization. Historically, such costs havebeen treated as a reduction of capital pro-ceeds from the transaction, and not as aseparate intangible asset that is amortiz-able over a useful life. See Rev. Rul. 69–330, 1969–1 C.B. 51; Affiliated CapitalCorp. v. Commissioner, 88 T.C. 1157(1987).

In addition, the proposed regulations donot allow safe harbor amortization for capi-talized transaction costs that facilitate a re-structuring or reorganization of a businessentity. As discussed below, comments arerequested regarding the appropriateness ofapplying the safe harbor amortization pe-riod to certain of these costs.

1. Acquirer’s Costs in a TaxableAcquisition

The safe harbor amortization provisionsdo not apply to transaction costs properlycapitalized by an acquirer to facilitate theacquisition of the stock or assets of a tar-get corporation in a taxable acquisition. Insuch a case, existing law provides that trans-action costs are properly capitalized to thebasis of the stock or assets acquired. SeeWoodward v. Commissioner, 397 U.S. 572(1970). In the case of a stock acquisition,the capitalized transaction costs are not am-ortizable, but offset any subsequent gain orloss realized on the disposition of the stock.In the case of an asset acquisition, the capi-talized transaction costs generally may berecovered as part of the recovery of the ba-sis of the assets.

2. Target’s Costs in a TaxableAcquisition

The safe harbor amortization rules alsodo not apply to transaction costs incurredby a target to facilitate the acquisition ofits assets by an acquirer in a taxable trans-action. In such a case, the transaction costsgenerally are an offset against any gain orloss realized by the target on the disposi-tion of its assets.

While the proposed regulations do notallow safe harbor amortization of transac-tion costs capitalized by a target to facili-tate the acquisition of its stock by anacquirer in a taxable transaction, the IRS

and Treasury Department request com-ments on whether safe harbor amortiza-tion should be allowed in such a transaction.Existing law provides no useful life forthese capitalized costs, and little guid-ance concerning when taxpayers may re-cover these costs. See, e.g., INDOPCO, Inc.v. Commissioner, 503 U.S. 79, 84 (1992)(indicating that where no specific asset oruseful life can be ascertained, a capital-ized cost is deducted upon dissolution ofthe enterprise). The IRS and Treasury De-partment believe that the application of asafe harbor amortization period to such costsmight help to eliminate much of the cur-rent controversy that exists concerning theproper treatment of these costs.

3. Acquirer’s and Target’s Costs in aTax-Free Acquisition

In determining whether the safe har-bor amortization provision should apply totransaction costs that facilitate a tax-free ac-quisition, threshold issues exist regardingthe proper treatment of capitalized costs.Comments are requested concerning the fol-lowing issues:

(a) Should an acquirer’s capitalizedtransaction costs in a tax-free acquisition ofa target be added to the acquirer’s basis inthe target’s stock or assets acquired? If so,should amortization of such costs under thesafe harbor amortization provision be pro-hibited on the ground that the capitalizedcosts are properly recovered as part of therecovery of the basis of the assets (in thecase of a transaction treated as an asset ac-quisition) or upon the disposition of thestock (in the case of a transaction treatedas a stock acquisition)? On the other hand,if the carryover basis rules of section 362(b)of the Code prohibit the acquirer from in-creasing its basis in the acquired stock orassets by the amount of the capitalizedtransaction costs, should the capitalizedtransaction costs be viewed as a separateintangible asset with an indefinite usefullife?

(b) Should a target’s capitalized trans-action costs in a tax-free acquisition that istreated as a stock acquisition be viewed asa separate intangible asset with an indefi-nite useful life?

(c) Should a target’s capitalized trans-action costs in a tax-free acquisition that istreated as an asset acquisition be viewed asan intangible asset with an indefinite use-ful life, or are such costs better viewed as

2003–5 I.R.B. 382 February 3, 2003

a reduction of target’s amount realized oras an increase in target’s basis in its as-sets immediately prior to the acquisition?

(d) If an acquirer’s (or a target’s) capi-talized transaction costs are viewed as aseparate intangible asset with an indefi-nite useful life, should amortization be per-mitted for such costs under the safe harboramortization provision, or does section197(e)(8) of the Code evince a Congres-sional intent to prohibit any amortization oftransaction costs capitalized in a tax-free re-organization?

(e) To what extent should the safe har-bor amortization provision apply to capi-talized transaction costs that facilitate tax-free transactions other than the acquisitivetransactions discussed above (e.g., trans-actions under sections 351 and 355)?

4. Costs to Facilitate a Borrowing

Existing law requires that capitalizedtransaction costs incurred to borrow money(debt issuance costs) be deducted over theterm of the debt. For example, see Enochv. Commissioner, 57 T.C. 781 (1972). Theregulations do not propose to change thistreatment. Accordingly, the safe harbor am-ortization provision does not apply to capi-talized debt issuance costs. However, inorder to conform the rules for debt issu-ance costs with the rules for original is-sue discount, the proposed regulationsgenerally require the use of a constant yieldmethod to determine how much of thesecosts are deductible each year by the bor-rower. See proposed § 1.446–5.

VIII. Computer Software Issues

The ANPRM requested public com-ment on the rules and principles that shouldapply in distinguishing acquired softwarefrom developed software. Under existinglaw, costs to acquire software are appro-priately capitalized and may be amortizedover 36 months or, in some cases, 15 years.Sections 167(f) and 197(d)(1)(C)(iii). Coststo develop software, on the other hand, maybe deducted as incurred in accordance withRev. Proc. 2000–50, 2000–2 C.B. 601.

The determination of whether softwareis developed or acquired is a factual in-quiry that depends on an analysis of the ac-tivities performed by the various parties tothe software transaction. While a few com-mentators identified factors that help to dis-tinguish acquired software from developedsoftware, commentators also suggested that

this issue should be addressed in separateguidance, and not in the proposed regula-tions.

The IRS and Treasury Department agreethat the determination of whether com-puter software is acquired or developedraises issues that are beyond the scope ofthese proposed regulations. Accordingly, theproposed regulations do not provide rulesfor distinguishing acquired software fromdeveloped software. These issues will be ad-dressed in subsequent guidance.

Many commentators suggested that theproposed regulations should provide guid-ance concerning the treatment of costs toimplement acquired software. For example,commentators noted that issues often ariseregarding the extent to which section 263(a)requires capitalization of costs to imple-ment Enterprise Resource Planning (ERP)software. ERP software is an enterprise-wide database software system that inte-grates business functions such as financialaccounting, sales and distribution, materi-als management, and production planning.Implementation of an ERP system may takeseveral years and generally involves vari-ous categories of costs, including (1) coststo acquire the ERP software package fromthe vendor, (2) costs to install the acquiredERP software on the taxpayer’s computerhardware and to configure the software tothe taxpayer’s needs through the use of theoptions and templates embedded in the soft-ware, (3) software development costs, and(4) costs to train employees in the use ofthe new software.

The proposed regulations do not spe-cifically address the treatment of ERP soft-ware. However, the IRS and TreasuryDepartment expect that the final regula-tions will address these costs and, subjectto the simplifying conventions provided inthe regulations for employee compensa-tion, overhead, and de minimis transac-tion costs, will treat such costs in a mannerconsistent with the treatment prescribed inPrivate Letter Ruling 200236028 (June 4,2002) (available in the IRS Freedom of In-formation Act Reading Room, 1111 Con-stitution Avenue, NW, Washington, DC20224). The IRS and Treasury Depart-ment request comments on the treatment ofERP implementation costs under the prin-ciples contained in these proposed regula-tions.

IX. Proposed Effective Date

These regulations are proposed to be ap-plicable on the date on which the final regu-lations are published in the FederalRegister. The regulations provide rules ap-plicable to taxpayers that seek to change amethod of accounting to comply with therules contained in the final regulations. Tax-payers may not change a method of ac-counting in reliance upon the rulescontained in these proposed regulations un-til the rules are published as final regula-tions in the Federal Register.

Upon publication of the final regula-tions, taxpayers must follow the appli-cable procedures for obtaining theCommissioner’s automatic consent to achange in accounting method. The pro-posed regulations provide that any changein a method of accounting is made usingan adjustment under section 481(a), but thatsuch adjustment is determined by takinginto account only amounts paid or incurredon or after the date the final regulations arepublished in the Federal Register.

The IRS and Treasury Department areconcerned about the potential administra-tive burden on taxpayers and the IRS thatmay result from a section 481(a) adjust-ment that takes into account amounts paidor incurred prior to the effective date of theregulations. Given the potential for sec-tion 481(a) adjustments that originate manyyears prior to the effective date of the regu-lations, the IRS and Treasury Departmentquestion whether adequate documenta-tion is available to compute the adjust-ment with reasonable accuracy.

The IRS and Treasury Department re-quest comments on whether there are cir-cumstances in which it is appropriate topermit a change in method of accountingto be made using an adjustment under sec-tion 481(a) that takes into account amountspaid or incurred prior to the effective dateof the regulations. If there are such cir-cumstances, comments are requested on theappropriate number of taxable years priorto the effective date of the regulations thattaxpayers should be permitted to look backfor purposes of computing the adjustment.Finally, the IRS and Treasury Departmentrequest comments on any additional termsand conditions for changes in methods ofaccounting that would be helpful to tax-payers in adopting the rules contained inthese regulations.

February 3, 2003 383 2003–5 I.R.B.

Special Analyses

It has been determined that this noticeof proposed rulemaking is not a signifi-cant regulatory action as defined in Ex-ecutive Order 12866. Therefore, a regulatoryassessment is not required. It also has beendetermined that section 553(b) of the Ad-ministrative Procedure Act (5 U.S.C. chap-ter 5) does not apply to these regulations,and, because the regulations do not im-pose a collection of information on smallentities, the Regulatory Flexibility Act (5U.S.C. chapter 6) does not apply. Pursu-ant to section 7805(f) of the Code, this no-tice of proposed rulemaking will besubmitted to the Chief Counsel for Advo-cacy of the Small Business Administra-tion for comment on its impact on smallbusiness.

Comments and Public Hearing

Before these proposed regulations areadopted as final regulations, considerationwill be given to any written (a signed origi-nal and eight (8) copies) or electronic com-ments that are submitted timely to the IRS.The IRS and Treasury Department requestcomments on the clarity of the proposedrules and how they can be made easier tounderstand. All comments will be avail-able for public inspection and copying.

A public hearing has been scheduled forApril 22, 2003, beginning at 10 a.m. in theIRS Auditorium, Internal Revenue Build-ing, 1111 Constitution Avenue, NW, Wash-ington, DC. Due to building securityprocedures, visitors must enter at the Con-stitution Avenue entrance. In addition, allvisitors must present photo identification toenter the building. Because of access re-strictions, visitors will not be admitted be-yond the immediate entrance area more than30 minutes before the hearing starts. For in-formation about having your name placedon the building access list to attend the hear-ing, see the “FOR FURTHER INFORMA-TION CONTACT” section of this preamble.

The rules of 26 CFR 601.601(a)(3) ap-ply to the hearing. Persons who wish topresent oral comments at the hearing mustsubmit electronic or written comments andan outline of the topics to be discussed andthe time to be devoted to each topic (signedoriginal and eight (8) copies) by April 1,2003. A period of 10 minutes will be al-lotted to each person for making com-ments. An agenda showing the schedule ofspeakers will be prepared after the dead-

line for receiving outlines has passed. Cop-ies of the agenda will be available free ofcharge at the hearing.


The principal author of these proposedregulations is Andrew J. Keyso of the Of-fice of Associate Chief Counsel (IncomeTax and Accounting). However, other per-sonnel from the IRS and Treasury Depart-ment participated in their development.

* * * * *

Proposed Amendments to theRegulations

Accordingly, 26 CFR part 1 is proposedto be amended as follows:

PART I — INCOME TAXES


Authority: 26 U.S.C. 7805 * * *Par. 2. Section 1.167(a)–3 is amended

by:1. Adding a paragraph designation and

heading to the undesignated paragraph.2. Adding paragraph (b).The additions read as follows:

§ 1.167(a)–3 Intangibles.

(a) In general. * * *(b) Safe harbor amortization for cer-

tain intangible assets — (1) Amortizationperiod. For purposes of determining the de-preciation allowance referred to in para-graph (a) of this section, a taxpayer maytreat an intangible asset as having a use-ful life equal to 15 years unless —

(i) An amortization period for the in-tangible asset is specifically prescribed orprohibited by the Internal Revenue Code,regulations, or other published guidance;

(ii) The intangible asset is described in§ 1.263(a)–4(c) (relating to intangibles ac-quired from another person) or § 1.263(a)–4(d)(2) (relating to created financialinterests);

(iii) The intangible asset has a useful lifethat is readily ascertainable; or

(iv) The intangible asset is described in§ 1.263(a)–4(d)(8) (relating to certain ben-efits arising from the provision, produc-tion, or improvement of real property), inwhich case the taxpayer may treat the in-tangible asset as having a useful life equalto 25 years.

(2) Applicability to restructurings, re-organizations, and acquisitions of capi-tal. The safe harbor amortization periodprovided by paragraph (b)(1) of this sec-tion does not apply to an amount requiredto be capitalized by § 1.263(a)–4(b)(1)(iii)(relating to amounts paid to facilitate a re-structuring, reorganization or transaction in-volving the acquisition of capital).

(3) Depreciation method. A taxpayer thatdetermines its depreciation allowance for anintangible asset using the 15-year amorti-zation period prescribed by paragraph (b)(1)of this section (or the 25-year amortiza-tion period in the case of an intangible as-set described in § 1.263(a)–4(d)(8)) mustdetermine the allowance by amortizing thebasis of the intangible asset (as determinedunder section 167(c) and without regard tosalvage value) ratably over the amortiza-tion period beginning on the first day of themonth in which the intangible asset isplaced in service by the taxpayer. The in-tangible asset is not eligible for amortiza-tion in the month of disposition.

Par. 3. Section 1.263(a)–4 is added toread as follows:

§ 1.263(a)–4 Amounts paid to acquire,create, or enhance intangible assets.

(a) Overview. This section provides rulesfor applying section 263(a) to amounts paidto acquire, create, or enhance intangible as-sets. Except to the extent provided in para-graph (d)(8) of this section, the rulesprovided by this section do not apply toamounts paid to acquire, create, or en-hance tangible assets. Paragraph (b) of thissection provides a general principle of capi-talization. Paragraphs (c) and (d) of this sec-tion identify intangibles for whichcapitalization is specifically required un-der the general principle. Paragraph (e) ofthis section provides rules for determin-ing the extent to which taxpayers must capi-talize transaction costs. Paragraph (f) of thissection provides a 12-month rule intendedto simplify the application of the generalprinciple to certain payments that createbenefits of a brief duration. Additional rulesand examples relating to these provisionsare provided in paragraphs (g) through (n)of this section. The applicability date of therules in this section is provided in para-graph (o) of this section.

(b) Capitalization of intangible assets —(1) In general. Except as otherwise pro-vided in chapter 1 of the Internal Rev-enue Code, a taxpayer must capitalize —

2003–5 I.R.B. 384 February 3, 2003

(i) An amount paid to acquire, create, orenhance an intangible asset (within themeaning of paragraph (b)(2) of this sec-tion);

(ii) An amount paid to facilitate (withinthe meaning of paragraph (e)(1) of this sec-tion) the acquisition, creation, or enhance-ment of an intangible asset; and

(iii) An amount paid to facilitate (withinthe meaning of paragraph (e)(1) of this sec-tion) a restructuring or reorganization of abusiness entity or a transaction involvingthe acquisition of capital, including a stockissuance, borrowing, or recapitalization.

(2) Intangible asset — (i) In general. Forpurposes of this section, the term intan-gible asset means —

(A) An intangible described in para-graph (c) of this section (relating to ac-quired intangibles);

(B) An intangible described in para-graph (d) of this section (relating to cer-tain created or enhanced intangibles);

(C) A separate and distinct intangible as-set within the meaning of paragraph (b)(3)of this section; or

(D) A future benefit identified in pub-lished guidance in the Federal Register orin the Internal Revenue Bulletin (see§ 601.601(d)(2)(ii)(b) of this chapter) as anintangible asset for which capitalization isrequired under this section.

(ii) Published guidance. Any publishedguidance identifying a future benefit as anintangible asset for which capitalization isrequired under paragraph (b)(2)(i)(D) of thissection applies only to amounts paid on orafter the date of publication of the guid-ance.

(3) Separate and distinct intangible as-set — (i) Definition. The term separate anddistinct intangible asset means a propertyinterest of ascertainable and measurablevalue in money’s worth that is subject toprotection under applicable state or fed-eral law and the possession and control ofwhich is intrinsically capable of being sold,transferred, or pledged (ignoring any re-strictions imposed on assignability). The de-termination of whether an amount is paidto acquire, create, or enhance a separate anddistinct intangible asset is made as of thetaxable year during which the payment ismade.

(ii) Creation or termination of contractrights. Amounts paid to another party to cre-ate or originate an agreement with that partythat produces rights or benefits for the tax-

payer do not create a separate and dis-tinct intangible asset within the meaning ofthis paragraph (b)(3). Further, amounts paidto another party to terminate an agree-ment with that party do not create a sepa-rate and distinct intangible asset within themeaning of this paragraph (b)(3). See para-graphs (d)(2), (6) and (7) of this section forrules that specifically require capitaliza-tion of amounts paid to create or termi-nate certain agreements. See paragraph(e)(1)(ii) of this section for rules relatingto the treatment of certain termination pay-ments that facilitate another transaction forwhich capitalization is required under thissection.

(c) Acquired intangibles — (1) In gen-eral. A taxpayer must capitalize amountspaid to another party to acquire an intan-gible from that party in a purchase or simi-lar transaction. Intangibles within the scopeof this paragraph (c) include, but are notlimited to, the following (if acquired fromanother party in a purchase or similartransaction):

(i) An ownership interest in a corpora-tion, partnership, trust, estate, limited li-ability company, or other similar entity.

(ii) A debt instrument, deposit, strippedbond, stripped coupon (including a servic-ing right treated for federal income tax pur-poses as a stripped coupon), regular interestin a REMIC or FASIT, or any other intan-gible treated as debt for federal income taxpurposes.

(iii) A financial instrument, including, butnot limited to —

(A) A letter of credit;(B) A credit card agreement;(C) A notional principal contract;(D) A foreign currency contract;(E) A futures contract;(F) A forward contract (including an

agreement under which the taxpayer has theright and obligation to provide or to ac-quire property (or to be compensated forsuch property));

(G) An option (including an agreementunder which the taxpayer has the right toprovide or to acquire property (or to becompensated for such property)); and

(H) Any other financial derivative.(iv) An endowment contract, annuity

contract, or insurance contract that has ormay have cash value.

(v) Non-functional currency.(vi) A lease contract.(vii) A patent or copyright.

(viii) A franchise, trademark or trade-name (as defined in § 1.197–2(b)(10)).

(ix) An assembled workforce (as de-fined in § 1.197–2(b)(3)).

(x) Goodwill (as defined in § 1.197–2(b)(1)) or going concern value (as de-fined in § 1.197–2(b)(2)).

(xi) A customer list.(xii) A servicing right (for example, a

mortgage servicing right).(xiii) A customer-based intangible (as de-

fined in § 1.197–2(b)(6)) or supplier-basedintangible (as defined in § 1.197–2(b)(7)).

(xiv) Computer software.(2) Readily available software. An

amount paid to obtain a nonexclusive li-cense for software that is (or has been)readily available to the general public onsimilar terms and has not been substan-tially modified (within the meaning of§ 1.197–2(c)(4)) is treated for purposes ofthis paragraph (c) as an amount paid to an-other party to acquire an intangible fromthat party in a purchase or similar trans-action.

(3) Intangibles acquired from an em-ployee. Amounts paid to an employee to ac-quire an intangible from that employee arenot required to be capitalized under this sec-tion if the amounts are treated as compen-sation for personal services includible in theemployee’s income under section 61 or 83.For purposes of this section, whether an in-dividual is an employee is determined in ac-cordance with the rules contained in section3401(c) and the regulations thereunder.

(4) Examples. The following examplesillustrate the rules of this paragraph (c):

Example 1. Financial instrument. X corpora-tion, a commercial bank, purchases a portfolio of ex-isting loans from Y corporation, another financialinstitution. X pays Y $2,000,000 in exchange for theportfolio. The $2,000,000 paid to Y constitutes anamount paid to acquire an intangible from Y and mustbe capitalized.

Example 2. Option. W corporation owns all of theoutstanding stock of X corporation. Y corporation holdsa call option entitling it to purchase from W all of theoutstanding stock of X at a certain price per share. Zcorporation acquires the call option from Y in ex-change for $5,000,000. The $5,000,000 paid to Y con-stitutes an amount paid to acquire an intangible fromY and must be capitalized.

Example 3. Ownership interest in a corpora-tion. Same as Example 2, but assume Z exercises itsoption and purchases from W all of the outstandingstock of X in exchange for $100,000,000. The$100,000,000 paid to W constitutes an amount paidto acquire an intangible from W and must be capi-talized.

Example 4. Customer list. N corporation, a re-tailer, sells its products exclusively through its cata-log and mail order system. N purchases a customer

February 3, 2003 385 2003–5 I.R.B.

list from R corporation. N pays R $100,000 in ex-change for the customer list. The $100,000 paid to Rconstitutes an amount paid to acquire an intangiblefrom R and must be capitalized.

Example 5. Lease. V corporation seeks to leasecommercial property in a prominent downtown lo-cation of city R. V identifies desirable property in cityR that is currently under lease by X corporation to Wcorporation under a 10-year assignable lease. V paysW $50,000 to acquire the lease and relocates its op-erations from city O to city R. The $50,000 paid toW constitutes an amount paid to W to acquire an in-tangible from W and must be capitalized.

Example 6. Goodwill. Z corporation pays W cor-poration $10,000,000 to purchase all of the assets ofW in a transaction that constitutes an applicable as-set acquisition under section 1060(c). Of the$10,000,000 consideration paid in the transaction,$9,000,000 is allocable to tangible assets purchasedfrom W and $1,000,000 is allocable to goodwill. The$1,000,000 allocable to goodwill constitutes an amountpaid to W to acquire intangibles from W and must becapitalized.

(d) Created intangibles — (1) In gen-eral. Except as provided in paragraph (f)of this section (relating to the 12-monthrule), a taxpayer must capitalize amountspaid to create or enhance an intangible de-scribed in this paragraph (d).

(2) Financial interests — (i) In gen-eral. A taxpayer must capitalize amountspaid to another party to create or origi-nate with that party any of the following fi-nancial interests, whether or not the interestis regularly traded on an established market:

(A) An ownership interest in a corpo-ration, partnership, trust, estate, limited li-ability company, or other similar entity.

(B) A debt instrument, deposit, strippedbond, stripped coupon (including a servic-ing right treated for federal income tax pur-poses as a stripped coupon), regular interestin a REMIC or FASIT, or any other intan-gible treated as debt for federal income taxpurposes.

(C) A financial instrument, including, butnot limited to —

(1) A letter of credit;(2) A credit card agreement;(3) A notional principal contract;(4) A foreign currency contract;(5) A futures contract;(6) A forward contract (including an

agreement under which the taxpayer has theright and obligation to provide or to ac-quire property (or to be compensated forsuch property));

(7) An option (including an agreementunder which the taxpayer has the right toprovide or to acquire property (or to becompensated for such property)); and

(8) Any other financial derivative.

(D) An endowment contract, annuitycontract, or insurance contract that has ormay have cash value.

(E) Non-functional currency.(ii) Exception for current and prior sales.

An amount is not required to be capital-ized under paragraph (d)(2)(i)(C)(6) or (7)of this section if the amount is allocable toproperty required to be provided or ac-quired by the taxpayer prior to the end ofthe taxable year in which the amount ispaid.

(iii) Coordination with other provisionsof this paragraph (d). An amount describedin this paragraph (d)(2) that is also de-scribed elsewhere in paragraph (d) of thissection is treated as described only in thisparagraph (d)(2).

(iv) Examples. The following examplesillustrate the rules of this paragraph (d)(2):

Example 1. Loan. X corporation, a commercialbank, makes a loan to A in the principal amount of$250,000. Under paragraph (d)(2)(i)(B) of this sec-tion, the $250,000 principal amount of the loan paidto A constitutes an amount paid to another party tocreate a financial instrument with that party and mustbe capitalized.

Example 2. Option. W corporation owns all of theoutstanding stock of X corporation. Y corporation paysW $1,000,000 in exchange for W’s grant of a 3-yearcall option to Y permitting Y to purchase all of theoutstanding stock of X at a certain price per share. Un-der paragraph (d)(2)(i)(C)(7) of this section, Y’s pay-ment of $1,000,000 to W constitutes an amount paidto another party to create or originate an option withthat party and must be capitalized.

Example 3. Partnership interest. Z corporationpays $10,000 to P, a partnership, in exchange for anownership interest in P. Under paragraph (d)(2)(i)(A)of this section, Z’s payment of $10,000 to P consti-tutes an amount paid to another party to create an own-ership interest in a partnership with that party and mustbe capitalized.

Example 4. Take or pay contract. Q corpora-tion, a producer of natural gas, pays $1,000,000 to Rduring 2002 to induce R corporation to enter into a5-year “take or pay” gas purchase contract. Under thecontract, R is liable to pay for a specified minimumamount of gas, whether or not R takes such gas. Un-der paragraph (d)(2)(i)(C)(6) of this section, Q’s pay-ment is an amount paid to another party to induce thatparty to enter into an agreement providing Q the rightand obligation to provide property or be compen-sated for such property, regardless of whether the prop-erty is provided. Because the agreement does notrequire that the property be provided prior to the endof the taxable year in which the amount is paid, Qmust capitalize the entire $1,000,000 paid to R.

Example 5. Agreement to provide property. P cor-poration pays R corporation $1,000,000 in exchangefor R’s agreement to purchase 1,000 units of P’s prod-uct at any time within the three succeeding calendaryears. The agreement describes P’s $1,000,000 as asales discount. Under paragraph (d)(2)(i)(C)(6) of thissection, P’s $1,000,000 payment is an amount paid toinduce R to enter into an agreement providing P the

right and obligation to provide property. Because theagreement does not require that the property be pro-vided prior to the end of the taxable year in which theamount is paid, P must capitalize the entire $1,000,000payment.

Example 6. Customer incentive payment. S cor-poration, a computer manufacturer, seeks to developa business relationship with V corporation, a com-puter retailer. As an incentive to encourage V to pur-chase computers from S, S enters into an agreementwith V under which S agrees that, if V purchases$20,000,000 of computers from S within 3 years fromthe date of the agreement, S will pay V $2,000,000on the date that V reaches the $20,000,000 thresh-old. V reaches the $20,000,000 threshold during thethird year of the agreement, and S pays V $2,000,000.S is not required to capitalize its payment to V un-der this paragraph (d)(2) because the payment doesnot provide S the right to provide property. More-over, the agreement between S and V requires that thecomputers be provided prior to the end of the tax-able year in which the $2,000,000 is paid. In addi-tion, as provided in paragraph (b)(3)(ii) of this section,S’s $2,000,000 payment does not create or enhancea separate and distinct intangible asset for S withinthe meaning of paragraph (b)(3)(i) of this section.

Example 7. Sales discount. P corporation, a sofamanufacturer that uses the calendar year for federalincome tax purposes, seeks to develop a business re-lationship with R corporation, a furniture retailer. In2002, P enters into a 5-year agreement with R un-der which P agrees to reimburse 10 percent of the pur-chase price paid by R if R purchases more than 1,000sofas in a single order. In addition, under the agree-ment, R agrees to purchase 2,000 sofas from P in asingle order for delivery during 2002. At the time theagreement is executed, P pays R $20,000, reflectingthe 10 percent discount on the first 2,000 sofas to bepurchased by R during 2002. The $20,000 paymentprovides P the right and obligation to provide prop-erty (2,000 sofas). Nevertheless, because the agree-ment requires that the sofas be provided prior to theend of the taxable year in which the amount is paid,P is not required to capitalize its $20,000 payment un-der this paragraph (d)(2). In addition, as provided inparagraph (b)(3)(ii) of this section, P’s $20,000 pay-ment does not create or enhance a separate and dis-tinct intangible asset for P within the meaning ofparagraph (b)(3)(i) of this section.

(3) Prepaid expenses — (i) In general.A taxpayer must capitalize amounts pre-paid for benefits to be received in the fu-ture.

(ii) Examples. The following examplesillustrate the rules of this paragraph (d)(3):

Example 1. Prepaid insurance. N corporation, anaccrual method taxpayer, pays $10,000 to an in-surer to obtain an insurance policy with a 3-year term.The $10,000 is an amount prepaid by N for benefitsto be received in the future and must be capitalizedunder this paragraph (d)(3).

Example 2. Prepaid rent. X corporation, a cashmethod taxpayer, enters into a 24-month lease of of-fice space. At the time of the lease signing, X pre-pays $240,000. No other amounts are due under thelease. The $240,000 is an amount prepaid by X forbenefits to be received in the future and must be capi-talized under this paragraph (d)(3).

2003–5 I.R.B. 386 February 3, 2003

(4) Certain memberships and privileges— (i) In general. A taxpayer must capital-ize amounts paid to an organization to ob-tain or renew a membership or privilegefrom that organization. A taxpayer is not re-quired to capitalize under this paragraph(d)(4) an amount paid to obtain certifica-tion of the taxpayer’s products, services, orbusiness processes.


Example 1. Hospital privilege. B, a physician, pays$10,000 to Y corporation to obtain lifetime staff privi-leges at a hospital operated by Y. B must capitalizethe $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 so-cial club. X must capitalize the $50,000 payment un-der this paragraph (d)(4).

Example 3. Product rating. V corporation, an au-tomobile manufacturer, pays W corporation, a na-tional quality ratings association, $100,000 to conducta study and provide a rating of the quality and safetyof a line of V’s automobiles. V’s payment is an amountpaid to obtain a certification of V’s product and is notrequired to be capitalized under this paragraph (d)(4).

Example 4. Business process certification. Z cor-poration, a manufacturer, seeks to obtain a certifica-tion that its quality control standards meet a series ofinternational standards known as ISO 9000. Z pays$50,000 to an independent registrar to obtain a cer-tification from the registrar that Z’s quality manage-ment system conforms to the ISO 9000 standard. Z’spayment is an amount paid to obtain a certificationof Z’s business processes and is not required to becapitalized under this paragraph (d)(4).

(5) Certain rights obtained from a gov-ernmental agency — (i) In general. A tax-payer must capitalize amounts paid to agovernmental agency to obtain or renew atrademark, trade name, copyright, license,permit, franchise, or other similar rightgranted by that governmental agency.


Example 1. Business license. X corporation pays$15,000 to state Y to obtain a business license that isvalid indefinitely. Under this paragraph (d)(5), theamount paid to state Y is an amount paid to a gov-ernment agency for a right granted by that agency. Ac-cordingly, 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 topractice law in state Z that is valid indefinitely, pro-vided A adheres to the requirements governing thepractice of law in state Z. Under this paragraph (d)(5),the amount paid to state Z is an amount paid to a gov-ernment agency for a right granted by that agency. Ac-cordingly, A must capitalize the $1,000 payment.

(6) Certain contract rights — (i) In gen-eral. Except as otherwise provided in thisparagraph (d)(6), a taxpayer must capital-ize amounts paid to another party to in-duce that party to enter into, renew, orrenegotiate —

(A) An agreement providing the tax-payer the right to use tangible or intan-gible property or the right to becompensated for the use of such prop-erty;

(B) An agreement providing the tax-payer the right to provide or to acquire ser-vices (or the right to be compensated forsuch services); or

(C) A covenant not to compete or anagreement having substantially the same ef-fect as a covenant not to compete (ex-cept, in the case of an agreement thatrequires the performance of services, to theextent that the amount represents reason-able compensation for services actually ren-dered).

(ii) De minimis amounts. A taxpayer isnot required to capitalize amounts paid toanother party (or parties) to induce thatparty (or those parties) to enter into, re-new, or renegotiate an agreement describedin paragraph (d)(6)(i) of this section if theaggregate of all amounts paid to that party(or those parties) with respect to the agree-ment does not exceed $5,000. If the ag-gregate of all amounts paid to the otherparty (or parties) with respect to that agree-ment exceeds $5,000, then all amounts mustbe capitalized. In general, a taxpayer mustdetermine whether the rules of this para-graph (d)(6)(ii) apply by accounting for theamounts paid with respect to each agree-ment. However, a taxpayer may elect to es-tablish one or more pools of agreements forpurposes of determining the amounts paidwith respect to an agreement. Under thispooling method, the amounts paid with re-spect to each agreement included in the poolis equal to the average amount paid withrespect to all agreements included in thepool. A taxpayer computes the averageamount paid with respect to all agreementsincluded in the pool by dividing the sumof all amounts paid with respect to allagreements included in the pool by thenumber of agreements included in the pool.See paragraph (h) of this section for addi-tional rules relating to pooling.

(iii) Exceptions — (A) Current and priorsales. An amount is not required to be capi-talized under paragraph (d)(6)(i)(B) of thissection if the amount is allocable to ser-vices required to be provided or acquiredby the taxpayer prior to the end of the tax-able year in which the amount is paid.

(B) Lessee construction allowances.Paragraph (d)(6)(i) of this section does not

apply to amounts paid by a lessor to a les-see as a construction allowance for tan-gible property (see, for example, section110).

(iv) Examples. The following examplesillustrate the rules of this paragraph (d)(6):

Example 1. New lease agreement. V seeks to leasecommercial property in a prominent downtown lo-cation of city R. V pays the owner of the commer-cial property $50,000 as an inducement to enter intoa 10-year lease with V. V’s payment is an amount paidto another party to induce that party to enter into anagreement providing V the right to use tangible prop-erty. Because the $50,000 payment exceeds $5,000,no portion of the amount paid to Z is de minimis forpurposes of paragraph (d)(6)(ii) of this section. Un-der paragraph (d)(6)(i)(A) of this section, V must capi-talize the entire $50,000 payment.

Example 2. Modification of lease agreement. Part-nership Y leases a piece of equipment for use in itsbusiness from Z corporation. When the lease has a re-maining term of 3 years, Y requests that Z modify thelease by extending the remaining term by 5 years. Ypays $50,000 to Z in exchange for Z’s agreement tomodify the existing lease. Y’s payment of $50,000 isan amount paid to induce Z to renegotiate an agree-ment providing Y the right to use property. Becausethe $50,000 payment exceeds $5,000, no portion ofthe amount paid to Z is de minimis for purposes ofparagraph (d)(6)(ii) of this section. Under paragraph(d)(6)(i)(A) of this section, Y must capitalize the en-tire $50,000 paid to induce Z to renegotiate the lease.

Example 3. Covenant not to compete. R corpo-ration enters into an agreement with A, an individual,that prohibits A from competing with R for a periodof three years. To encourage A to enter into the agree-ment, R agrees to pay A $100,000 upon the signingof the agreement. R’s payment is an amount paid toanother party to induce that party to enter into a cov-enant not to compete. Because the $100,000 pay-ment exceeds $5,000, no portion of the amount paidto A is de minimis for purposes of paragraph (d)(6)(ii)of this section. Under paragraph (d)(6)(i)(C) of thissection, R must capitalize the entire $100,000 paid toA to induce A to enter into the covenant not to com-pete.

Example 4. De minimis payments. X corpora-tion is engaged in the business of providing wire-less telecommunications services to customers. Toinduce customer B to enter into a 3-year telecommu-nications contract, X provides B with a free wire-less telephone. X pays $300 to purchase the wirelesstelephone. X’s provision of a wireless telephone to Bis an amount paid to B to induce B to enter into anagreement providing X the right to provide services,as described in paragraph (d)(6)(i)(B) of this sec-tion. Because the amount of the inducement is $300,the amount of the inducement is de minimis underparagraph (d)(6)(ii) of this section. Accordingly, X isnot required to capitalize the amount of the induce-ment provided to B.

(7) Certain contract terminations — (i)In general. A taxpayer must capitalizeamounts paid to another party to termi-nate —

(A) A lease of real or tangible personalproperty between the taxpayer (as lessor)and that party (as lessee);

February 3, 2003 387 2003–5 I.R.B.

(B) An agreement that grants that partythe exclusive right to acquire or use the tax-payer’s property or services or to conductthe taxpayer’s business; or

(C) An agreement that prohibits the tax-payer from competing with that party orfrom acquiring property or services from acompetitor of that party.


Example 1. Termination of exclusive license agree-ment. On July 1, 2001, N enters into a license agree-ment with R corporation under which N grants R theexclusive right to manufacture and distribute goodsusing N’s design and trademarks for a period of 10years. On June 30, 2003, N pays R $5,000,000 in ex-change for R’s agreement to terminate the exclusivelicense agreement. N’s payment to terminate its li-cense agreement with R constitutes a payment to ter-minate an exclusive license to use the taxpayer’sproperty, as described in paragraph (d)(7)(i)(B) of thissection. Accordingly, N must capitalize its $5,000,000payment to R.

Example 2. Termination of exclusive distribu-tion agreement. On March 1, 2001, L, a manufac-turer, enters into an agreement with M granting M theright to be the sole distributor of L’s products in stateX for 10 years. On July 1, 2004, L pays M $50,000in exchange for M’s agreement to terminate the dis-tribution agreement. L’s payment to terminate its agree-ment with M constitutes a payment to terminate anexclusive right to acquire L’s property, as describedin paragraph (d)(7)(i)(B) of this section. Accord-ingly, L must capitalize its $50,000 payment to M.

Example 3. Termination of covenant not to com-pete. On February 1, 2001, Y corporation enters intoa covenant not to compete with Z corporation that pro-hibits Y from competing with Z in city V for a pe-riod of 5 years. On January 31, 2003, Y pays Z$1,000,000 in exchange for Z’s agreement to termi-nate the covenant not to compete. Y’s payment to ter-minate the covenant not to compete with Z constitutesa payment to terminate an agreement that prohibits Yfrom competing with Z, as described in paragraph(d)(7)(i)(C) of this section. Accordingly, Y must capi-talize its $1,000,000 payment to Z.

Example 4. Termination of exclusive right to ac-quire property. W corporation owns one-half of theoutstanding stock of X corporation. On July 1, 2002,W grants Y corporation a 5-year call option that per-mits Y to purchase all of W’s stock in X. On June 30,2004, W pays Y $50,000 to terminate the option. W’spayment to terminate the option with Y constitutes apayment to terminate an exclusive right to acquire W’sproperty, as described in paragraph (d)(7)(i)(B) of thissection. Accordingly, W must capitalize its $50,000payment to Y.

Example 5. Termination of supply contract. Dur-ing 2000, Q corporation enters into a 10-year agree-ment with R corporation under which R agrees tofulfill all of Q’s requirements for packaging materi-als and supplies used by Q in the distribution of Q’sgoods. During 2005, Q determines that its contract withR has become unprofitable for Q and seeks to termi-nate the contract. Q pays R $100,000 to terminate thecontract. Q’s payment to terminate the supply con-tract with R is a payment to terminate an agreementnot described in this paragraph (d)(7). Accordingly,

Q is not required to capitalize the $100,000 pay-ment to R under this paragraph (d)(7). In addition, asprovided in paragraph (b)(3)(ii) of this section, Q’s$1,000,000 payment does not create or enhance a sepa-rate and distinct intangible asset for Q within the mean-ing of paragraph (b)(3)(i) of this section.

Example 6. Termination of merger agreement. Ncorporation enters into an agreement with U corpo-ration under which N and U agree to merge. Prior tothe merger, N decides that its business will be moresuccessful if it does not merge with U. N pays U$10,000,000 to terminate the agreement. At the timeof the payment, N is not under an agreement to mergewith any other entity. N’s payment to terminate themerger agreement with U is a payment to terminatean agreement not described in this paragraph (d)(7).Accordingly, N is not required to capitalize the$10,000,000 payment under this paragraph (d)(7). Inaddition, as provided in paragraph (b)(3)(ii) of this sec-tion, N’s $10,000,000 payment does not create or en-hance a separate and distinct intangible asset for Nwithin the meaning of paragraph (b)(3)(i) of this sec-tion.

(8) Certain benefits arising from the pro-vision, production, or improvement of realproperty — (i) In general. A taxpayer mustcapitalize amounts paid for real property re-linquished to another, or amounts paid toproduce or improve real property owned byanother, if the real property can reason-ably be expected to produce significant eco-nomic benefits for the taxpayer.

(ii) Exclusions. A taxpayer is not re-quired to capitalize an amount under para-graph (d)(8)(i) of this section to the extentthe payment —

(A) Is part of a transaction involving thesale of the real property by the taxpayer;

(B) Is part of the sale of services by thetaxpayer to produce or improve the realproperty;

(C) Is a payment by the taxpayer forsome other property or service provided tothe taxpayer; or

(D) Is a payment by the taxpayer to an-other party to create an intangible describedin paragraph (d) of this section (other thanin this paragraph (d)(8)).

(iii) Real property. For purposes of thisparagraph (d)(8), real property includesproperty that is affixed to real property andthat will ordinarily remain affixed for an in-definite period of time, such as roads,bridges, tunnels, pavements, wharves anddocks, breakwaters and sea walls, eleva-tors, power generation and transmission fa-cilities, and pollution control facilities.

(iv) Impact fees and dedicated improve-ments. Paragraph (d)(8)(i) of this sectiondoes not apply to amounts paid to satisfyone-time charges imposed by a state or lo-cal government against new development

(or expansion of existing development) tofinance specific offsite capital improve-ments for general public use that are ne-cessitated by the new or expandeddevelopment. In addition, paragraph (d)(8)(i)of this section does not apply to amountspaid for real property or improvements toreal property constructed by the taxpayerwhere the real property or improvementsbenefit new development or expansion ofexisting development, are immediatelytransferred to a state or local governmentfor dedication to the general public use, andare maintained by the state or local gov-ernment. See section 263A and the regu-lations thereunder for capitalization rulesthat apply to amounts referred to in thisparagraph (d)(8)(iv).

(v) Examples. The following examplesillustrate the rules of this paragraph (d)(8):

Example 1. Amount paid to produce real prop-erty owned by another. W corporation operates a quarryon the east side of a river in city Z and a crusher onthe west side of the river. City Z’s existing bridgesare of insufficient capacity to be traveled by trucksin transferring stone from W’s quarry to its crusher.As a result, the efficiency of W’s operations is greatlyreduced. W contributes $1,000,000 to City Z to de-fray in part the cost of construction of a publiclyowned bridge capable of accommodating W’s trucks.W’s payment to city Z is an amount paid to pro-duce real property (within the meaning of paragraph(d)(8)(iii) of this section) that can reasonably be ex-pected to produce significant economic benefits forW. Under paragraph (d)(8)(i) of this section, W mustcapitalize the $1,000,000 paid to city Z.

Example 2. Dedicated improvements. X corpo-ration is engaged in the development and sale of resi-dential real estate. In connection with a residential realestate project under construction by X in city Z, X isrequired by city Z to construct ingress and egress roadsto and from its project and immediately transfer theroads to city Z for dedication to general public use.The roads will be maintained by city Z. X pays its sub-contractor $100,000 to construct the ingress and egressroads. X’s payment is a dedicated improvement withinthe meaning of paragraph (d)(8)(iv) of this section. Ac-cordingly, X is not required to capitalize the $100,000payment under this paragraph (d)(8). See section 263Aand the regulations thereunder for capitalization rulesthat apply to amounts referred to in paragraph (d)(8)(iv)of this section.

(9) Defense or perfection of title to in-tangible property — (i) In general. A tax-payer must capitalize amounts paid toanother party to defend or perfect title tointangible property where that other partychallenges the taxpayer’s title to the intan-gible property.

(ii) Example. The following example il-lustrates the rules of this paragraph (d)(9):

Example. Defense of title. R corporation claims toown an exclusive patent on a particular technology.U corporation brings a lawsuit against R, claiming that

2003–5 I.R.B. 388 February 3, 2003

U is the true owner of the patent, and that R stole thetechnology from U. The sole issue in the suit in-volves the validity of R’s patent. R chooses to settlethe suit by paying U $100,000 in exchange for U’srelease of all future claim to the patent. R’s pay-ment to U is an amount paid to defend or perfect titleto intangible property under paragraph (d)(9) of thissection and must be capitalized.

(e) Transaction costs — (1) Scope of fa-cilitate — (i) In general. An amount is paidto facilitate a transaction described in para-graph (b)(1)(ii) of this section (an acqui-sition, creation, or enhancement of anintangible asset) or to facilitate a transac-tion described in paragraph (b)(1)(iii) of thissection (a restructuring or reorganization ofa business entity or a transaction involv-ing the acquisition of capital) if the amountis paid in the process of pursuing the trans-action. Whether an amount is paid in theprocess of pursuing a transaction is deter-mined based on all facts and circumstances.The fact that an amount would (or wouldnot) have been paid but-for the transac-tion is not relevant in determining whetherthe amount is paid to facilitate the trans-action.

(ii) Treatment of termination paymentsin integrated transactions. An amount paidto terminate (or facilitate the termination of)an existing agreement constitutes an amountpaid to facilitate a transaction referred toin paragraph (e)(1)(i) of this section if thetransaction is expressly conditioned on thetermination of the existing agreement.

(iii) Ordering rules. An amount requiredto be capitalized under paragraph (b)(1)(i)of this section does not facilitate a trans-action referred to in paragraph (e)(1)(i) ofthis section. In addition, an amount paid tofacilitate a borrowing does not facilitate an-other transaction (other than the borrow-ing) referred to in paragraph (e)(1)(i) of thissection.

(2) Transaction. For purposes of this sec-tion, the term transaction means all of thefactual elements comprising an acquisi-tion, creation, or enhancement of an intan-gible asset (or a restructuring, reorgan-ization, or transaction involving the acqui-sition of capital) and includes a series ofsteps carried out as part of a single plan.Thus, a transaction can involve more thanone invoice and more than one intangibleasset. For example, a purchase of intan-gible assets under one purchase agree-ment may constitute a single transaction,notwithstanding the fact that the acquisi-tion involves multiple intangible assets and

the amounts paid to facilitate the acquisi-tion are capable of being allocated amongthe various intangible assets acquired.

(3) Simplifying conventions — (i) In gen-eral. For purposes of this paragraph (e),compensation paid to employees (includ-ing bonuses and commissions paid to em-ployees), overhead, and de minimis costs(within the meaning of paragraph (e)(3)(ii)of this section) are treated as amounts thatdo not facilitate a transaction referred to inparagraph (e)(1)(i) of this section. For pur-poses of this section, whether an individualis an employee is determined in accor-dance with the rules contained in section3401(c) and the regulations thereunder.

(ii) De minimis costs — (A) In gen-eral. Except as provided in paragraph(e)(3)(ii)(B) of this section, the term deminimis costs means amounts referred to inparagraph (e)(1)(i) of this section that arepaid with respect to a transaction if, in theaggregate, the amounts do not exceed$5,000. If the amounts exceed $5,000, noportion of the amounts is a de minimis costwithin the meaning of this paragraph(e)(3)(ii)(A). In determining the amount oftransaction costs paid with respect to atransaction, a taxpayer generally must ac-count for the actual costs paid with re-spect to the transaction. However, a taxpayermay elect to determine the amount of trans-action costs paid with respect to a trans-action using the average cost poolingmethod described in paragraph (e)(3)(ii)(C)of this section.

(B) Treatment of commissions. The termde minimis costs does not include commis-sions paid to facilitate the acquisition of anintangible described in paragraphs (c)(1)(i)through (v) of this section or to facilitatethe creation or origination of an intan-gible described in paragraphs (d)(2)(i)(A)through (E) of this section.

(C) Average cost pooling method. A tax-payer may elect to establish one or morepools of similar transactions for purposesof determining the amount of transactioncosts paid with respect to a transaction. Un-der this pooling method, the amount oftransaction costs paid with respect to eachtransaction included in the pool is equal tothe average transaction costs paid with re-spect to all transactions included in the pool.A taxpayer computes the average transac-tion costs paid with respect to all transac-tions included in the pool by dividing thesum of all transaction costs paid with re-

spect to all transactions included in the poolby the number of transactions included inthe pool. See paragraph (h) of this sec-tion for additional rules relating to pool-ing.

(4) Special rules applicable to certaintrade or business acquisition and reorga-nization transactions — (i) Acquisitivetransactions — (A) In general. Except asprovided in paragraph (e)(4)(i)(B) of thissection, in the case of an acquisition of atrade or business (whether structured as anacquisition of stock or of assets and whetherthe taxpayer is the acquirer in the acqui-sition or the target of the acquisition), anamount paid in the process of pursuing theacquisition facilitates the acquisition withinthe meaning of this paragraph (e) only ifthe amount relates to activities performedon or after the earlier of —

(1) The date on which the acquirer sub-mits to the target a letter of intent, offer let-ter, or similar written communicationproposing a merger, acquisition, or otherbusiness combination; or

(2) The date on which an acquisitionproposal is approved by the taxpayer’sBoard of Directors (or committee of theBoard of Directors) or, in the case of a tax-payer that is not a corporation, the date onwhich the acquisition proposal is approvedby the appropriate governing officials of thetaxpayer.

(B) Inherently facilitative amounts. Anamount paid in the process of pursuing anacquisition facilitates that acquisition if theamount is inherently facilitative, regard-less of whether the amount is paid for ac-tivities performed prior to the datedetermined under paragraph (e)(4)(i)(A) ofthis section. An amount is inherently fa-cilitative if the amount is paid for activi-ties performed in determining the value ofthe target, negotiating or structuring thetransaction, preparing and reviewing trans-actional documents, preparing and review-ing regulatory filings required by thetransaction, obtaining regulatory approvalof the transaction, securing advice on thetax consequences of the transaction, secur-ing an opinion as to the fairness of thetransaction, obtaining shareholder approvalof the transaction, or conveying property be-tween the parties to the transaction.

(C) Success-based fees. An amount paidthat is contingent on the successful clos-ing of an acquisition is an amount paid tofacilitate the acquisition except to the ex-

February 3, 2003 389 2003–5 I.R.B.

tent that evidence clearly demonstrates thatsome portion of the amount is allocable toactivities that do not facilitate the acquisi-tion.

(D) Integration costs. An amount paidto integrate the business operations of theacquirer and the target does not facilitatethe acquisition within the meaning of para-graph (e)(1)(i) of this section, regardless ofwhen the integration activities occur.

(ii) Divisive transactions — (A) Stockdistributions. An amount paid to facili-tate a distribution of stock to the share-holders of a taxpayer is not required to becapitalized under this section if the dives-titure is required by law, regulatory man-date, or court order unless the divestitureitself facilitates another transaction re-ferred to in paragraph (e)(1)(i) of this sec-tion. For example, where a taxpayer, tocomply with a new law requiring the tax-payer to divest itself of a particular tradeor business, contributes that trade or busi-ness to a new subsidiary and distributes thestock of the subsidiary to the taxpayer’sshareholders, amounts paid to facilitate thedistribution do not facilitate a transactionreferred to in paragraph (e)(1)(i) of this sec-tion and are not required to be capital-ized under this section. Conversely, wherea taxpayer, to secure regulatory approval forits proposed acquisition of a target corpo-ration, complies with a government man-date to divest itself of a particular trade orbusiness and contributes the trade or busi-ness to a new subsidiary and distributes thestock of the subsidiary to the taxpayer’sshareholders, amounts paid to facilitate thedivestiture are amounts paid to facilitate theacquisition of the target and must be capi-talized under this section.

(B) Taxable asset sales. An amount paidto facilitate the sale of assets in a transac-tion not described in section 368 is not re-quired to be capitalized under this sectionunless the sale is required by law, regula-tory mandate, or court order and the saleitself facilitates another transaction re-ferred to in paragraph (e)(1)(i) of this sec-tion. For example, where a targetcorporation, in preparation for a merger withan acquirer, sells assets that are not de-sired by the acquirer, amounts paid to fa-cilitate the sale are not required to becapitalized as amounts paid to facilitate themerger. Conversely, where a taxpayer, in or-der to secure regulatory approval for its pro-posed acquisition of a target corporation,

complies with a government mandate to di-vest itself of a particular trade or busi-ness and sells the assets of that trade orbusiness in a taxable sale, amounts paid tofacilitate the sale are amounts paid to fa-cilitate the acquisition of the target and mustbe capitalized under this section.

(iii) Defense against a hostile acquisi-tion attempt — (A) In general. An amountpaid to defend against an acquisition of thetaxpayer in a hostile acquisition attempt isnot an amount paid to facilitate a transac-tion within the meaning of paragraph(e)(1)(i) of this section. In determiningwhether an acquisition attempt is hostile, allrelevant facts and circumstances are takeninto account. The mere fact that the tax-payer receives an unsolicited offer from apotential acquirer, or rejects an initial of-fer from a potential acquirer, is not deter-minative of whether an acquisition attemptis hostile. On the other hand, the fact thatthe taxpayer implements defensive mea-sures in response to the acquisition at-tempt is evidence that the acquisitionattempt is hostile. Once an acquisition at-tempt ceases to be hostile, an amount paidby the taxpayer in the process of pursu-ing the acquisition of its stock by the ac-quirer is an amount paid to facilitate atransaction referred to in paragraph (e)(1)(i)of this section.

(B) Exception for amounts paid to fa-cilitate another capital transaction. Anamount paid to defend against an acquisi-tion of the taxpayer in a hostile acquisi-tion attempt does not include a paymentthat, while intended to thwart a hostile ac-quisition attempt by an acquirer, itself fa-cilitates another transaction referred to inparagraph (e)(1)(i) of this section. Thus, forexample, an amount paid to effect a re-capitalization in an effort to defend againsta hostile acquisition attempt is not anamount paid to defend against an acquisi-tion of the taxpayer in a hostile acquisi-tion attempt for purposes of paragraph(e)(4)(iii)(A) of this section.

(5) Coordination with paragraph (d) ofthis section. In the case of an amount paidto facilitate the creation or enhancement ofan intangible described in paragraph (d) ofthis section, the provisions of this para-graph (e) apply regardless of whether a pay-ment described in paragraph (d) is made.

(6) Application to stock issuance costsof open-end regulated investment compa-nies. Amounts paid by an open-end regu-

lated investment company (within themeaning of section 851) to facilitate an is-suance of its stock are treated as amountsthat do not facilitate a transaction referredto in paragraph (e)(1)(i) of this section un-less such amounts are paid during the ini-tial stock offering period.

(7) Examples. The following examplesillustrate the rules of this paragraph (e):

Example 1. Costs to facilitate. In December 2002,R corporation, a calendar year taxpayer, enters intonegotiations with X corporation to lease commer-cial property from X for a period of 25 years. R paysA, its outside legal counsel, $4,000 in December 2002for services rendered by A during December in as-sisting with negotiations with X. In January 2003, Rand X finalize the terms of the lease and execute thelease agreement. R pays B, another of its outside le-gal counsel, $2,000 in January 2003 for services ren-dered by B during January in drafting the leaseagreement. The agreement between R and X is anagreement providing R the right to use property, asdescribed in paragraph (d)(6)(i)(A) of this section. R’spayments to its outside counsel are amounts paid tofacilitate the creation of the agreement. As providedin paragraph (e)(3)(ii)(A) of this section, R must ag-gregate its transaction costs for purposes of deter-mining 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 withinthe meaning of paragraph (e)(3)(ii)(A) of this sec-tion. Accordingly, R must capitalize the $4,000 paidto A and the $2,000 paid to B under paragraph(b)(1)(ii) of this section.

Example 2. Costs to facilitate. Q corporation paysits outside counsel $20,000 to assist Q in register-ing its stock with the Securities and Exchange Com-mission. Q is not a regulated investment companywithin the meaning of section 851. Q’s payments toits outside counsel are amounts paid to facilitate theissuance of stock. Accordingly, Q must capitalize its$20,000 payment under paragraph (b)(1)(iii) of thissection.

Example 3. Costs to facilitate. Partnership X leasesits manufacturing equipment from Y corporation un-der a 10-year lease. During 2002, when the lease hasa remaining term of 4 years, X enters into a writtenagreement with Z corporation, a competitor of Y, un-der which X agrees to lease its manufacturing equip-ment from Z, subject to the condition that X firstsuccessfully terminates its lease with Y. X pays Y$50,000 in exchange for Y’s agreement to terminatethe equipment lease. Because the new lease is ex-pressly conditioned on the termination of the old leaseagreement, as provided in paragraph (e)(1)(ii) of thissection, X’s payment of $50,000 facilitates the cre-ation of a new lease. Accordingly, X must capital-ize the $50,000 termination payment under paragraph(b)(1)(ii) of this section.

Example 4. Costs to facilitate. W corporation en-ters into a lease agreement with X corporation un-der which W agrees to lease property to X for a periodof 5 years. W pays its outside counsel $7,000 for le-gal services rendered in drafting the lease agree-ment and negotiating with X. The agreement betweenW and X is an agreement providing W the right tobe compensated for the use of property, as describedin paragraph (d)(6)(i)(A) of this section. Under para-

2003–5 I.R.B. 390 February 3, 2003

graph (e)(1)(i) of this section, W’s payment to its out-side counsel is an amount paid to facilitate W’screation of an intangible asset. As provided by para-graph (e)(5) of this section, W must capitalize its$7,000 payment to outside counsel notwithstanding thefact that W made no payment described in para-graph (d)(6)(i) of this section to induce X to enter intothe agreement.

Example 5. Costs to facilitate. Q corporation seeksto acquire all of the outstanding stock of Y corpora-tion. To finance the acquisition, Q must issue new debt.Q pays an investment banker $25,000 to market thedebt to the public and pays its outside counsel $10,000to prepare the offering documents for the debt. Q’spayment of $35,000 facilitates a borrowing and mustbe capitalized under paragraph (b)(1)(iii) of this sec-tion. As provided in paragraph (e)(1)(iii) of this sec-tion, Q’s payment does not facilitate the acquisitionof Y, notwithstanding the fact that Q incurred the newdebt to finance its acquisition of Y.

Example 6. Costs that do not facilitate. X cor-poration brings a legal action against Y corporationto recover lost profits resulting from Y’s alleged in-fringement of X’s copyright. Y does not challenge X’scopyright, but argues that it did not infringe upon X’scopyright. X pays its outside counsel $25,000 for le-gal 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 orperfection of title to intangible property. Thus, theamount paid to outside counsel does not facilitate thecreation or enhancement of an intangible asset de-scribed in paragraph (d)(9) of this section. In addi-tion, the amount paid to outside counsel does notfacilitate the acquisition, creation, or enhancement ofany other intangible asset described in this section. Ac-cordingly, X is not required to capitalize its $25,000payment under this section.

Example 7. De minimis rule. W corporation, acommercial bank, acquires a portfolio containing 100loans from Y corporation. W pays an independentagent a commission of $10,000 for brokering the ac-quisition. The commission is an amount paid to fa-cilitate W’s acquisition of an intangible asset. Theacquisition of the loan portfolio is a single transac-tion within the meaning of paragraph (e)(2) of this sec-tion. Because the amounts paid to facilitate thetransaction exceed $5,000, the amounts are not de mini-mis as defined in paragraph (e)(3)(ii)(A) of this sec-tion. Accordingly, W must capitalize the $10,000commission under paragraph (b)(1)(ii) of this sec-tion.

Example 8. Compensation and overhead. P cor-poration, a commercial bank, maintains a loan acqui-sition department whose sole function is to acquireloans from other financial institutions. As provided inparagraph (e)(3)(i) of this section, P is not requiredto capitalize any portion of the compensation paid tothe employees in its loan acquisition department orany portion of its overhead allocable to the loan ac-quisition department.

Example 9. Corporate acquisition. (i) On Feb-ruary 1, 2002, R corporation decides to investigate theacquisition of three potential targets: T corporation,U corporation, and V corporation. R’s considerationof T, U, and V represents the consideration of threedistinct transactions, any or all of which R might con-summate. On March 1, 2002, R issues a letter of in-tent to T and stops pursuing U and V. On July 1, 2002,R acquires the stock of T in a transaction described

in section 368. R pays $1,000,000 to an investmentbanker and $50,000 to its outside counsel to con-duct due diligence on the targets, determine the valueof T, U, and V, negotiate and structure the transac-tion with T, draft the merger agreement, secure share-holder approval, prepare SEC filings, and obtain thenecessary regulatory approvals.

(ii) Under paragraph (e)(4)(i)(A) of this section,

the amounts paid to conduct due diligence on T, U,

and V prior to March 1, 2002 (the date of the letter

of intent), are not amounts paid to facilitate the ac-

quisition of the stock of T and are not required to be

capitalized under this paragraph (e). However, the

amounts paid to conduct due diligence on T on and

after March 1, 2002, are amounts paid to facilitate the

acquisition of the stock of T and must be capital-

ized under paragraph (b)(1)(ii) of this section.

(iii) Under paragraph (e)(4)(i)(B) of this section,

the amounts paid to determine the value of T, nego-

tiate and structure the transaction with T, draft the

merger agreement, secure shareholder approval, pre-

pare SEC filings, and obtain necessary regulatory ap-

provals are inherently facilitative amounts paid to

facilitate the acquisition of the stock of T and must

be capitalized, regardless of whether those activities

occur prior to March 1, 2002.

(iv) Under paragraph (e)(4)(i)(B) of this section,

the amounts paid to determine the value of U and V

are inherently facilitative amounts paid to facilitate the

acquisition of U or V and must be capitalized. How-

ever, these fees may be recovered under section 165

in the taxable year that R abandons the planned merg-

ers with U and V.Example 10. Corporate acquisition; employee bo-

nus. Assume the same facts as in Example 9, exceptR pays a bonus of $10,000 to one of its corporate of-ficers who negotiated the acquisition of T. As pro-vided by paragraph (e)(3)(i) of this section, Y is notrequired to capitalize any portion of the bonus paidto the corporate officer.

Example 11. Corporate acquisition; integrationcosts. Assume the same facts as in Example 9, ex-cept that, before and after the acquisition is consum-mated, R incurs costs to relocate personnel andequipment, provide severance benefits to terminatedemployees, integrate records and information sys-tems, prepare new financial statements for the com-bined entity, and reduce redundancies in the combinedbusiness operations. Under paragraph (e)(4)(i)(D) ofthis section, these costs do not facilitate the acquisi-tion of T. Accordingly, R is not required to capital-ize any of these costs under this section.

Example 12. Corporate acquisition; compensa-tion to target’s employees. Assume the same facts asin Example 9, except that, prior to the acquisition, cer-tain employees of T held unexercised options is-sued pursuant to T’s incentive stock option plan. Theseoptions granted the employees the right to purchaseT stock at a fixed option price. The options did nothave a readily ascertainable value (within the mean-ing of § 1.83–7(b)), and thus no amount was in-cluded in the employees’ income when the optionswere granted. As a condition of the acquisition, T isrequired to terminate its incentive stock option plan.T therefore agrees to pay its employees who hold un-

exercised stock options the difference between the op-tion price and the current value of T’s stock inconsideration of their agreement to cancel their un-exercised options. Under paragraph (e)(3)(i) of this sec-tion, T is not required to capitalize the amounts paidto its employees.

Example 13. Corporate acquisition; retainer. Ycorporation’s outside counsel charges Y $60,000 forservices rendered in facilitating the friendly acquisi-tion of the stock of Y corporation by X corporation.Y has an agreement with its outside counsel underwhich Y pays an annual retainer of $50,000. Y’s out-side counsel has the right to offset amounts billed forany legal services rendered against the annual re-tainer. Pursuant to this agreement, Y’s outside coun-sel offsets $50,000 of the legal fees from theacquisition against the retainer and bills Y for the bal-ance of $10,000. The $60,000 legal fee is an amountpaid to facilitate the reorganization of Y as describedin paragraph (e)(1)(i) of this section. Y must capital-ize the full amount of the $60,000 legal fee.

Example 14. Corporate acquisition; antitrust de-fense costs. On March 1, 2002, V corporation en-ters into an agreement with X corporation to acquireall of the outstanding stock of X. On April 1, 2002,federal and state regulators file suit against V to pre-vent the acquisition of X on the ground that the ac-quisition violates antitrust laws. V enters into a consentagreement with regulators on May 1, 2002, that al-lows the acquisition to proceed, but requires V to holdseparate the business operations of X pending the out-come of the antitrust suit and subjects V to possibledivestiture. V acquires title to all of the outstandingstock of X on June 1, 2002. After June 1, 2002, theregulators pursue antitrust litigation against V seek-ing rescission of the acquisition. V pays $50,000 toits outside counsel for services rendered after June 1,2002, to defend against the antitrust litigation. V ul-timately prevails in the antitrust litigation. V’s coststo defend the antitrust litigation are costs to facili-tate its acquisition of the stock of X under para-graph (e)(1)(i) of this section and must be capitalized.Although title to the shares of X passed to V prior tothe date V incurred costs to defend the antitrust liti-gation, the amounts paid by V are paid in the pro-cess of pursuing the acquisition of the stock of Xbecause the acquisition was not complete until the an-titrust litigation was ultimately resolved. Because theamounts paid to defend the suit are not de minimiscosts within the meaning of paragraph (e)(3)(ii)(A) ofthis section, V must capitalize the full $50,000.

Example 15. Corporate acquisition; hostile de-fense costs. (i) Y corporation, a publicly traded cor-poration, becomes the target of a hostile takeoverattempt by Z corporation on January 15, 2002. In aneffort to defend against the takeover, Y pays legal feesto seek an injunction against the takeover and invest-ment banking fees to locate a potential “white knight”acquirer, as well as costs to effect a recapitalization.Y’s efforts to enjoin the takeover and locate a whiteknight acquirer are unsuccessful, and on March 15,2002, Y’s Board of Directors decides to abandon itsdefense against the takeover and negotiate with Z inan effort to obtain the highest possible price for itsshareholders. After Y abandons its defense against thetakeover, Y pays its investment bankers $1,000,000for a fairness opinion and for services rendered in ne-gotiating with Z.

(ii) Under paragraph (e)(4)(iii)(A) of this sec-tion, the legal fees paid by Y to seek an injunction

February 3, 2003 391 2003–5 I.R.B.

against the takeover and the investment banking feespaid to search for a white knight acquirer do not fa-cilitate the acquisition of Y by Z. Such amounts arepaid to defend against Z’s hostile takeover attempt andare not required to be capitalized under this section.

(iii) Under paragraph (e)(4)(iii)(B) of this sec-tion, the amounts paid by Y to effect a recapitaliza-tion are not amounts paid to defend against a hostileacquisition attempt. Accordingly, the amounts paid toeffect the recapitalization must be capitalized underparagraph (b)(1)(iii) of this section.

(iv) The $1,000,000 paid to the investment bank-ers after Y abandons its defense against the take-over is an amount paid to facilitate an acquisition ofY and must be capitalized under paragraph (b)(1)(iii)of this section.

Example 16. Corporate acquisition; break up fees.(i) N corporation enters into an agreement with U cor-poration under which U agrees to purchase all of theoutstanding stock of N for $70 per share. The agree-ment between N and U provides that if the acquisi-tion does not succeed, N will pay U $1,000,000 as abreak up fee. Prior to the closing of the acquisition,N enters into an agreement with W under which Wagrees to purchase all of the outstanding stock of Nfor $80 per share on the condition that N terminatesits pending acquisition agreement with U. N pays U$1,000,000 to terminate the acquisition agreement andN subsequently is acquired by W. Under paragraph(e)(1)(ii) of this section, the $1,000,000 paid to U isan amount paid to facilitate a transaction described inparagraph (b)(1)(iii) of this section. Accordingly, Nmust capitalize the $1,000,000 payment.

Example 17. Corporate acquisition; break up feesto white knight. Z corporation launches an unsolic-ited hostile tender offer of $70 per share for 55 per-cent of the outstanding shares of T corporation. In aneffort to defend against a takeover by Z, T enters intoan agreement with W corporation, a “white knight”acquirer, under which W agrees to pay $75 per sharefor all outstanding shares of T if T agrees to recom-mend the transaction to its shareholders. The agree-ment between T and W provides that if the acquisitionof T by W does not succeed, T will pay W $1,000,000as a break up fee. Prior to the acquisition of T by W,Z amends its offer to $85 per share for all of the out-standing shares of T. T’s Board of Directors con-cludes that Z’s amended offer is preferable andrecommends that its shareholders accept Z’s amendedoffer. Z subsequently acquires all of the outstandingshares of T for $85 per share. In accordance with itsagreement with W, T pays W $1,000,000 to termi-nate the acquisition agreement. The $1,000,000 paidto W does not facilitate Z’s acquisition of the out-standing shares of T. Under paragraph (e)(1)(ii) of thissection, T’s payment to W is not made pursuant to anagreement under which the acquisition of the out-standing shares of T by Z is expressly conditioned onthe termination of the agreement between T and W.

(f) 12-month rule — (1) In general —(i) Amounts paid to create or enhance anintangible asset. A taxpayer is not requiredto capitalize amounts paid to create or en-hance an intangible asset if the amounts do

not create or enhance any right or benefitfor the taxpayer that extends beyond the ear-lier of —

(A) 12 months after the first date onwhich the taxpayer realizes the right or ben-efit; or

(B) The end of the taxable year follow-ing the taxable year in which the paymentis made.

(ii) Transaction costs. A taxpayer is notrequired to capitalize amounts paid to fa-cilitate the creation or enhancement of anintangible asset if, by reason of paragraph(f)(1)(i) of this section, capitalization wouldnot be required for amounts paid to cre-ate or enhance that intangible asset.

(2) Duration of benefit for contract ter-minations. For purposes of this paragraph(f), amounts paid to terminate a contract orother agreement described in paragraph(d)(7)(i) of this section prior to its expira-tion date (or amounts paid to facilitate suchtermination) create a benefit for the tax-payer equal to the unexpired term of theagreement as of the date of the termina-tion.

(3) Inapplicability to created financialinterests and self-created amortizable sec-tion 197 intangibles. Paragraph (f)(1) of thissection does not apply to amounts paid tocreate or enhance an intangible describedin paragraph (d)(2) of this section (relat-ing to amounts paid to create or enhancefinancial interests) or to amounts paid tocreate or enhance an intangible asset thatconstitutes an amortizable section 197 in-tangible within the meaning of section197(c).

(4) Inapplicability to rights of indefi-nite duration. Paragraph (f)(1) of this sec-tion does not apply to amounts paid tocreate or enhance a right of indefinite du-ration. A right has an indefinite duration ifit has no period of duration fixed by agree-ment or by law, or if it is not based on aperiod of time, such as a right attribut-able to an agreement to provide or receivea fixed amount of goods or services. Forexample, a license granted by a govern-mental agency that permits the taxpayer tooperate a business conveys a right of in-definite duration if the license may be re-voked only upon the taxpayer’s violationof the terms of the license.

(5) Rights subject to renewal — (i) Ingeneral. For purposes of paragraph (f)(1)(i)of this section, the duration of a right in-

cludes any renewal period if, based on allof the facts and circumstances in exist-ence during the taxable year in which theright is created, the facts indicate a rea-sonable expectancy of renewal.

(ii) Reasonable expectancy of renewal.The following factors are significant in de-termining whether there exists a reason-able expectancy of renewal:

(A) Renewal history. The fact that simi-lar rights are historically renewed is evi-dence of a reasonable expectancy ofrenewal. On the other hand, the fact thatsimilar rights are rarely renewed is evi-dence of a lack of a reasonable expect-ancy of renewal. Where the taxpayer hasno experience with similar rights, or wherethe taxpayer holds similar rights only oc-casionally, this factor is less indicative ofa reasonable expectancy of renewal.

(B) Economics of the transaction. Thefact that renewal is necessary in order forthe taxpayer to earn back its investment inthe right is evidence of a reasonable ex-pectancy of renewal. For example, if a tax-payer pays $10,000 to enter into arenewable contract with an initial 9-monthterm that is expected to generate income tothe taxpayer of $1,000 per month, the factthat renewal is necessary in order for thetaxpayer to earn back its $10,000 induce-ment is evidence of a reasonable expect-ancy of renewal.

(C) Likelihood of renewal by other party.Evidence that indicates a likelihood of re-newal by the other party to a right, such asa bargain renewal option or similar ar-rangement, is evidence of a reasonable ex-pectancy of renewal. However, the mere factthat the other party will have the opportu-nity to renew on the same terms as areavailable to others, in a competitive auc-tion or similar process that is designed toreflect fair market value, is not evidence ofa reasonable expectancy of renewal.

(D) Terms of renewal. The fact that ma-terial terms of the right are subject to re-negotiation at the end of the initial term isevidence of a lack of a reasonable expect-ancy of renewal. For example, if the par-ties to an agreement must renegotiate priceor amount, the renegotiation requirement isevidence of a lack of a reasonable expect-ancy of renewal.

(iii) Safe harbor pooling method. In lieuof applying the reasonable expectancy ofrenewal test described in paragraph (f)(5)(ii)

2003–5 I.R.B. 392 February 3, 2003

of this section to each separate right cre-ated or enhanced during a taxable year, ataxpayer may establish one or more poolsof similar rights for which the initial termdoes not extend beyond the period de-scribed in paragraph (f)(1)(i) of this sec-tion and may apply the reasonableexpectancy of renewal test to each pool. Seeparagraph (h) of this section for additionalrules relating to pooling. The application ofparagraph (f)(1) of this section to each poolis determined in the following manner:

(A) All amounts (except de minimisamounts described in paragraph (d)(6)(ii)of this section) paid to create or enhancethe rights included in the pool and allamounts paid to facilitate the creation or en-hancement of the rights included in the poolare aggregated.

(B) If less than 20 percent of the rightsin the pool are reasonably expected to berenewed beyond the period prescribed inparagraph (f)(1)(i) of this section, all rightsin the pool are treated as having a dura-tion that does not extend beyond the pe-riod prescribed in paragraph (f)(1)(i) of thissection, and the taxpayer is not required tocapitalize under this section any portion ofthe aggregate amount described in para-graph (f)(5)(iii)(A) of this section.

(C) If more than 80 percent of the rightsin the pool are reasonably expected to berenewed beyond the period prescribed inparagraph (f)(1)(i) of this section, all rightsin the pool are treated as having a dura-tion that extends beyond the period pre-scribed in paragraph (f)(1)(i) of this section,and the taxpayer is required to capitalize un-der this section the aggregate amount de-scribed in paragraph (f)(5)(iii)(A) of thissection.

(D) If 20 percent or more, but 80 per-cent or less, of the rights in the pool are rea-sonably expected to be renewed beyond theperiod prescribed in paragraph (f)(1)(i) ofthis section, the aggregate amount describedin paragraph (f)(5)(iii)(A) of this section ismultiplied by the percentage of the rightsin the pool that are reasonably expected tobe renewed beyond the period prescribedin paragraph (f)(1)(i) of this section and thetaxpayer must capitalize the resultingamount under this section by treating suchamount as creating a separate intangible as-set.

(6) Rights terminable at will. A right isnot described in paragraph (f)(1)(i) of thissection merely because the right is termi-

nable at will by either party. However, forpurposes of paragraph (f)(5) of this sec-tion, the fact that similar rights are typi-cally terminated prior to renewal is relevantin determining whether there exists a rea-sonable expectancy of renewal for the right.

(7) Coordination with section 461. In thecase of a taxpayer using an accrual methodof accounting, the rules of this paragraph(f) do not affect the determination ofwhether a liability is incurred during the tax-able year, including the determination ofwhether economic performance has oc-curred with respect to the liability. See§ 1.461–4(d) for rules relating to economicperformance.

(8) Examples. The rules of this para-graph (f) are illustrated by the following ex-amples, in which it is assumed (unlessotherwise stated) that the taxpayer is a cal-endar year, accrual method taxpayer:

Example 1. Prepaid expenses. On December 1,2002, N corporation pays a $10,000 insurance pre-mium to obtain a property insurance policy with a1-year term that begins on February 1, 2003. Theamount paid by N is a prepaid expense described inparagraph (d)(3) of this section. Because the right orbenefit attributable to the $10,000 payment extendsbeyond the end of the taxable year following the tax-able year in which the payment is made, the 12-month rule provided by this paragraph (f) does notapply. N must capitalize the $10,000 payment.

Example 2. Prepaid expenses. Assume the samefacts as in Example 1, except that the policy has a termbeginning on December 15, 2002. The 12-month ruleof this paragraph (f) applies to the $10,000 paymentbecause the right or benefit attributable to the pay-ment neither extends more than 12 months beyond De-cember 15, 2002 (the first date the benefit is realizedby the taxpayer), nor beyond the taxable year fol-lowing the year in which the payment is made. Ac-cordingly, N is not required to capitalize the $10,000payment.

Example 3. Financial interests. On October 1,2002, X corporation makes a 9-month loan to B in theprincipal amount of $250,000. The principal amountof the loan paid to B constitutes an amount paid tocreate or originate a financial interest under para-graph (d)(2)(i)(B) of this section. The 9-month termof the loan does not extend beyond the period pre-scribed by paragraph (f)(1)(i) of this section. How-ever, as provided by paragraph (f)(3) of this section,the rules of this paragraph (f) do not apply to intan-gibles described in paragraph (d)(2) of this section.Accordingly, X must capitalize the $250,000 loanamount.

Example 4. Financial interests. X corporation ownsall of the outstanding stock of Z corporation. On De-cember 1, Y corporation, a calendar year taxpayer, paysX $1,000,000 in exchange for X’s grant of a 9-monthcall option to Y permitting Y to purchase all of theoutstanding stock of Z. Y’s payment to X consti-tutes an amount paid to create or originate an op-tion with X under paragraph (d)(2)(i)(C)(7) of thissection. The 9-month term of the option does not ex-tend beyond the period prescribed by paragraph (f)(1)(i)

of this section. However, as provided by paragraph(f)(3) of this section, the rules of this paragraph (f)do not apply to intangibles described in paragraph(d)(2) of this section. Accordingly, Y must capital-ize the $1,000,000 payment.

Example 5. License. (i) On July 1, 2002, R cor-poration pays $10,000 to state X to obtain a licenseto operate a business in state X for a period of 5 years.The terms of the license require R to pay state X anannual fee of $500 due on July 1 of each of the suc-ceeding four years. R pays the $500 fee on July 1 ofeach succeeding year as required by the license.

(ii) R’s payment of $10,000 is an amount paid toa governmental agency for a license granted by thatagency to which paragraph (d)(5) of this section ap-plies. Because R’s payment creates rights or ben-efits for R that extend beyond the end of 2003 (thetaxable year following the taxable year in which thepayment is made), the rules of this paragraph (f) donot apply to R’s payment. Accordingly, R must capi-talize the $10,000 payment.

(iii) R’s payment of each $500 annual fee is a pre-paid expense described in paragraph (d)(3) of this sec-tion. R is not required to capitalize the $500 fee ineach of the succeeding four taxable years. The rulesof this paragraph (f) apply to each such payment be-cause each payment provides a right or benefit to Rthat does not extend beyond 12 months after the firstdate on which R realizes the rights or benefits attrib-utable to the payment and does not extend beyond theend of the taxable year following the taxable year inwhich the payment is made.

Example 6. Lease. On December 1, 2002, W cor-poration, a calendar year taxpayer, enters into a leaseagreement with X corporation under which W agreesto lease property to X for a period of 9 months, be-ginning on December 1, 2002. W pays its outsidecounsel $7,000 for legal services rendered in draft-ing the lease agreement and negotiating with X. Theagreement between W and X is an agreement pro-viding W the right to be compensated for the use ofproperty, as described in paragraph (d)(6)(i)(A) of thissection. W’s $7,000 payment to its outside counsel isan amount paid to facilitate W’s creation of an in-tangible asset as described in paragraph (e)(1)(i) ofthis section. Under paragraph (f)(1)(ii) of this sec-tion, W’s payment to its outside counsel is not re-quired to be capitalized because, by reason ofparagraph (f)(1)(i) of this section (relating to the 12-month rule) an amount described in paragraph(d)(6)(i)(A) of this section to create the agreement be-tween W and X would not be required to be capital-ized under this section.

Example 7. Certain contract terminations. V cor-poration owns real property that it has leased to A fora period of 15 years. When the lease has a remain-ing unexpired term of 5 years, V requests that A agreeto terminate the lease, enabling V to use the prop-erty in its trade or business. V pays A $100,000 in ex-change for A’s agreement to terminate the lease. V’spayment to A to terminate the lease is described inparagraph (d)(7)(i)(A) of this section. Under para-graph (f)(2) of this section, V’s payment creates a ben-efit for V with a duration of 5 years, the remainingunexpired term of the lease as of the date of the ter-mination. Because the benefit attributable to the ex-penditure extends beyond 12 months after the first dateon which V realizes the rights or benefits attribut-able to the payment and beyond the end of the tax-able year following the taxable year in which the

February 3, 2003 393 2003–5 I.R.B.

payment is made, the rules of this paragraph (f) donot apply to the payment. V must capitalize the$100,000 payment.

Example 8. Certain contract terminations. As-sume the same facts as in Example 7, except the leaseis terminated when it has a remaining unexpired termof 10 months. Under paragraph f)(2) of this section,V’s payment creates a benefit for V with a durationof 10 months. The 12-month rule of this paragraph(f) applies to the payment because the benefit attrib-utable to the payment neither extends more than 12months beyond the date of termination (the first datethe benefit is realized by V) nor beyond the taxableyear following the year in which the payment is made.Accordingly, V is not required to capitalize the$100,000 payment.

Example 9. Certain contract terminations. M cor-poration enters into a 5-year agreement with X cor-poration under which X is required to provide M withservices over the term of the agreement. Under theterms of the agreement, either M or X may termi-nate the agreement without cause upon 30 days no-tice. M pays C, an individual, a $10,000 commissionfor services provided by C in locating X and bring-ing the parties together. The agreement between M andX is an agreement providing M the right to acquireservices as described in paragraph (d)(6)(i)(B) of thissection. M’s $10,000 payment to C is an amount paidto facilitate the creation of an intangible asset as de-scribed in paragraph (e)(1)(i) of this section. Be-cause the duration of the contract is 5 years, the 12-month rule contained in paragraph (f)(1)(i) of thissection does not apply, notwithstanding the fact thatthe agreement is terminable by either party withoutcause upon 30 days notice. M must capitalize the$10,000 commission payment.

Example 10. Coordination with section 461. (i)U corporation leases office space from W corpora-tion at a monthly rental rate of $2,000. On Decem-ber 31, 2002, U prepays its office rent expense for thefirst six months of 2003 in the amount of $12,000. Forpurposes of this example, it is assumed that the re-curring item exception provided by § 1.461–5 does notapply and that the lease between W and U is not a sec-tion 467 rental agreement as defined in section 467(d).

(ii) Under § 1.461–4(d)(3), U’s prepayment of rentis a payment for the use of property by U for whicheconomic performance occurs ratably over the pe-riod of time U is entitled to use the property. Accord-ingly, because economic performance with respect toU’s prepayment of rent does not occur until 2003, U’sprepaid rent is not incurred in 2002 and therefore isnot properly taken into account through capitaliza-tion, deduction, or otherwise in 2002. Thus, the rulesof this paragraph (f) do not apply to U’s prepay-ment of its rent.

(iii) Alternatively, assume that U uses the cashmethod of accounting and the economic performancerules in § 1.461–4 therefore do not apply to U. The12-month rule of this paragraph (f) applies to the$12,000 payment because the rights or benefits at-tributable to U’s prepayment of its rent do not ex-tend beyond December 31, 2003. Accordingly, U isnot required to capitalize its prepaid rent.

Example 11. Coordination with section 461. N cor-poration pays R corporation, an advertising and mar-keting firm, $40,000 on August 1, 2002, for advertisingand marketing services to be provided to N through-out calendar year 2003. For purposes of this ex-ample, 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 ser-vices to N by R for which economic performanceoccurs as the services are provided. Accordingly, be-cause economic performance with respect to N’s pre-paid advertising expense does not occur until 2003,N’s prepaid advertising expense is not incurred in 2002and therefore is not properly taken into account throughcapitalization, deduction, or otherwise in 2002. Thus,the rules of this paragraph (f) do not apply to N’s pay-ment.

(g) Treatment of capitalized transac-tion costs — (1) Costs described in para-graph (b)(1)(i) or (ii) of this section. Exceptin the case of amounts paid by an acquirerto facilitate an acquisition of stock or as-sets in a transaction described in section368, an amount required to be capitalizedby paragraph (b)(1)(i) or (ii) of this sec-tion is capitalized to the basis of the in-tangible asset acquired, created, orenhanced.

(2) Costs described in paragraph(b)(1)(iii) of this section — (i) Stock issu-ance or recapitalization. An amount paidto facilitate a stock issuance or a recapi-talization is not capitalized to the basis ofan intangible asset but is treated as a re-duction of the proceeds from the stock is-suance or the recapitalization.

(ii) [Reserved].(h) Special rules applicable to pooling

— (1) In general. The rules of this para-graph (h) apply to the pooling methods de-scribed in paragraph (d)(6)(ii) of this section(relating to de minimis rules applicable tocertain contract rights), paragraph(e)(3)(ii)(C) of this section (relating to deminimis rules applicable to transactioncosts), and paragraph (f)(5)(iii) of this sec-tion (relating to the application of the 12-month rule to renewable rights).

(2) Election to use pooling. An elec-tion to use a pooling method identified inparagraph (h)(1) of this section for any tax-able year is made by establishing one ormore pools for the taxable year in accor-dance with the rules governing the particu-lar pooling method and the rules prescribedby this paragraph (h). An election to use apooling method identified in paragraph(h)(1) of this section is irrevocable with re-spect to each pool established during thetaxable year.

(3) Definition of pool. A taxpayer mayuse any reasonable method of defining apool of similar transactions, agreements, orrights, including a method based on the typeof customer or the type of product pro-vided under a contract. However, a tax-

payer that elects to pool similar transactions,agreements, or rights must include in thepool all similar transactions, agreements, orrights arising during the taxable year.

(4) Consistency requirement. A taxpayerthat uses the pooling method described inparagraph (f)(5)(iii) of this section for pur-poses of applying the 12-month rule to aright or benefit —

(i) Must use the pooling methods de-scribed in paragraph (d)(6)(ii) of this sec-tion (relating to de minimis rules applicableto inducements) and paragraph (e)(3)(ii)(C)of this section (relating to de minimis rulesapplicable to transaction costs) for pur-poses of determining the amount paid tocreate, or facilitate the creation of, the rightor benefit; and

(ii) Must use the same pool for pur-poses of paragraph (d)(6)(ii) of this sec-tion and paragraph (e)(3)(ii)(C) of thissection as is used for purposes of para-graph (f)(5)(iii) of this section.

(i) [Reserved].(j) Application to accrual method tax-

payers. For purposes of this section, theterms amount paid and payment mean, inthe case of a taxpayer using an accrualmethod of accounting, a liability incurred(within the meaning of § 1.446–1(c)(1)(ii)).A liability may not be taken into accountunder this section prior to the taxable yearduring which the liability is incurred.

(k) Treatment of related parties and in-direct payments. For purposes of this sec-tion, references to a party other than thetaxpayer include persons related to that partyand persons acting for or on behalf of thatparty. Persons are related for purposes ofthis section only if their relationship is de-scribed in section 267(b) or 707(b) or theyare engaged in trades or businesses undercommon control within the meaning of sec-tion 41(f)(1).

(l) Examples. The following examples il-lustrate the rules of this section:

Example 1. License granted by a governmentalunit. (i) X corporation pays $25,000 to state R to ob-tain a license to sell alcoholic beverages in its res-taurant. The license is valid indefinitely, provided Xcomplies with all applicable laws regarding the saleof alcoholic beverages in state R. X pays its outsidecounsel $4,000 for legal services rendered in prepar-ing the license application and otherwise represent-ing X during the licensing process. In addition, Xdetermines that $2,000 of salaries paid to its employ-ees is allocable to services rendered by the employ-ees in obtaining the license.

(ii) X’s payment of $25,000 is an amount paid toa governmental unit to obtain a license granted by thatagency, as described in paragraph (d)(5)(i) of this sec-

2003–5 I.R.B. 394 February 3, 2003

tion. The right has an indefinite duration and consti-tutes an amortizable section 197 intangible.Accordingly, the provisions of paragraph (f) of thissection (relating to the 12-month rule) do not applyto X’s payment. X must capitalize its $25,000 pay-ment to obtain the license from state R.

(iii) As provided in paragraph (e)(3) of this sec-tion, X is not required to capitalize employee com-pensation because such amounts are treated as amountsthat do not facilitate the acquisition, creation, or en-hancement of an intangible asset. Thus, X is not re-quired to capitalize the $2,000 of employeecompensation allocable to the transaction.

(iv) X’s payment of $4,000 to its outside coun-sel is an amount paid to facilitate the creation of anintangible asset, as described in paragraph (e)(1)(i) ofthis section. Because X’s transaction costs do not ex-ceed $5,000, X’s transaction costs are de minimiswithin the meaning of paragraph (e)(3)(ii)(A) of thissection. Accordingly, X is not required to capitalizethe $4,000 payment to its outside counsel under thissection.

Example 2. Franchise agreement. (i) R corpora-tion is a franchisor of income tax return preparationoutlets. V corporation negotiates with R to obtain theright to operate an income tax return preparation out-let under a franchise from R. V pays an initial$100,000 franchise fee to R in exchange for the fran-chise agreement. In addition, V pays its outside coun-sel $4,000 to represent V during the negotiations withR. V also pays $2,000 to an industry consultant to ad-vise V during the negotiations with R.

(ii) Under paragraph (d)(6)(i)(A) of this sec-tion, V’s payment of $100,000 is an amount paid toanother party to induce that party to enter into anagreement providing V the right to use tangible or in-tangible property. Accordingly, V must capitalize its$100,000 payment to R. The franchise agreement isan amortizable section 197 intangible within the mean-ing of section 197(c). Accordingly, as provided in para-graph (f)(3) of this section, the 12-month rule containedin paragraph (f)(1)(i) of this section does not apply.

(iii) V’s payment of $4,000 to its outside coun-sel and $2,000 to the industry consultant are amountspaid to facilitate the creation of an intangible asset,as described in paragraph (e)(1)(i) of this section. Be-cause V’s aggregate transaction costs exceed $5,000,V’s transaction costs are not de minimis within themeaning of paragraph (e)(3)(ii)(A) of this section. Ac-cordingly, V must capitalize the $4,000 payment toits outside counsel and the $2,000 payment to the in-dustry consultant under this section into the basis ofthe franchise, as provided in paragraph (g)(1) of thissection.

Example 3. Covenant not to compete. (i) On De-cember 1, 2002, N corporation, a calendar year tax-payer, enters into a covenant not to compete with B,a key employee that is leaving the employ of N. Thecovenant not to compete prohibits B from compet-ing with N for a period of 9 months, beginning De-cember 1, 2002. N pays B $50,000 in full considerationfor B’s agreement not to compete. In addition, N paysits outside counsel $6,000 to facilitate the creation ofthe covenant not to compete with B.

(ii) Under paragraph (d)(6)(i)(C) of this sec-tion, N’s payment of $50,000 is an amount paid to an-other party to induce that party to enter into a covenantnot to compete with N. However, because the cov-enant not to compete has a duration that does not ex-tend beyond 12 months after the first date on which

N realizes the rights attributable to its payment (i.e.,December 1, 2002), the 12-month rule contained inparagraph (f)(1)(i) of this section applies. Accord-ingly, N is not required to capitalize its $50,000 pay-ment to B. In addition, as provided in paragraph(f)(1)(ii) of this section, N is not required to capital-ize its $6,000 payment to facilitate the creation of thecovenant not to compete.

Example 4. Corporate reorganization; initial pub-lic offering. Y corporation is a privately-owned com-pany. Y’s Board of Directors authorizes an initial publicoffering of Y’s stock in order to fund future growth.Y pays $5,000,000 in professional fees for invest-ment banking services related to the determination ofthe offering price and legal services related to the de-velopment of the offering prospectus and the regis-tration and issuance of stock. Under paragraph(b)(1)(iii) of this section, the $5,000,000 is an amountpaid to facilitate a transaction involving the acquisi-tion of capital. As provided in paragraph (g)(2)(i) ofthis section, Y must treat the $5,000,000 as a reduc-tion of the proceeds from the stock issuance.

Example 5. Demand-side management. (i) X cor-poration, a public utility engaged in generating anddistributing electrical energy, provides programs to itscustomers to promote energy conservation and en-ergy efficiency. These programs are aimed at reduc-ing electrical costs to X’s customers, building goodwillwith X’s customers, and reducing X’s future operat-ing and capital costs. X provides these programs with-out obligating any of its customers participating in theprograms to purchase power from X in the future. Un-der these programs, X pays a consultant to help in-dustrial customers design energy-efficientmanufacturing processes, to conduct “energy effi-ciency audits” that serve to identify for customers in-efficiencies in their energy usage patterns, and toprovide cash allowances to encourage residential cus-tomers to replace existing appliances with more en-ergy efficient appliances.

(ii) The amounts paid by X to the consultant arenot amounts to acquire, create, or enhance an intan-gible identified in paragraph (c) or (d) of this sec-tion or to facilitate such an acquisition, creation, orenhancement. In addition, the amounts do not cre-ate a separate and distinct intangible asset within themeaning of paragraph (b)(3) of this section. Accord-ingly, the amounts paid to the consultant are not re-quired to be capitalized under this section. While theamounts may serve to reduce future operating and capi-tal costs and create goodwill with customers, these ben-efits, without more, are not intangible assets for whichcapitalization is required under this section unless theInternal Revenue Service publishes guidance identi-fying these benefits as an intangible asset for whichcapitalization is required.

Example 6. Business process re-engineering. (i)V corporation manufactures its products using a batchproduction system. Under this system, V continu-ously produces component parts of its various prod-ucts and stockpiles these parts until they are neededin V’s final assembly line. Finished goods are stock-piled awaiting orders from customers. V discovers thatthis process ties up significant amounts of V’s capi-tal in work-in-process and finished goods invento-ries, and hires B, a consultant, to advise V onimproving the efficiency of its manufacturing opera-tions. B recommends a complete re-engineering of V’smanufacturing process to a process known as just-in-time manufacturing. Just-in-time manufacturing in-

volves reconfiguring a manufacturing plant to aconfiguration of “cells” where each team in a cell per-forms the entire manufacturing process for a particu-lar customer order, thus reducing inventory stockpiles.

(ii) V incurred three categories of costs to con-vert its manufacturing process to a just-in-time sys-tem. First, V paid B, a consultant, $250,000 inprofessional fees to implement the conversion of V’splant to a just-in-time system. Second, V paid C, a con-tractor, $100,000 to relocate and reconfigure V’s manu-facturing equipment from an assembly line layout toa configuration of cells. Third, V paid D, a consult-ant, $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 arenot amounts to acquire, create, or enhance an intan-gible identified in paragraph (c) or (d) of this sec-tion or to facilitate such an acquisition, creation, orenhancement. In addition, the amounts do not cre-ate a separate and distinct intangible asset within themeaning of paragraph (b)(3) of this section. Accord-ingly, the amounts paid to B, C, and D are not re-quired to be capitalized under this section. While theamounts produce long term benefits to V in the formof reduced inventory stockpiles, improved productquality, and increased efficiency, these benefits, with-out more, are not intangible assets for which capi-talization is required under this section unless theInternal Revenue Service publishes guidance identi-fying these benefits as an intangible asset for whichcapitalization is required.

Example 7. Defense of business reputation. (i) X,an investment adviser, serves as the fund manager ofa money market investment fund. X, like its com-petitors in the industry, strives to maintain a con-stant net asset value for its money market fund of$1.00 per share. During 2003, in the course of man-aging the fund assets, X incorrectly predicts the di-rection of market interest rates, resulting in significantinvestment losses to the fund. Due to these signifi-cant losses, X is faced with the prospect of report-ing a net asset value that is less than $1.00 per share.X is not aware of any investment adviser in its in-dustry that has ever reported a net asset value for itsmoney market fund of less than $1.00 per share. Xis concerned that reporting a net asset value of lessthan $1.00 per share will significantly harm its repu-tation as an investment adviser, and could lead to liti-gation by shareholders. X decides to contribute$2,000,000 to the fund in order to raise the net as-set value of the fund to $1.00 per share. This contri-bution is not a loan to the fund and does not give Xany ownership interest in the fund.

(ii) The $2,000,000 contribution is not an amountpaid to acquire, create, or enhance an intangible iden-tified in paragraph (c) or (d) of this section or to fa-cilitate such an acquisition, creation, or enhancement.In addition, the amount does not create a separate anddistinct intangible asset within the meaning of para-graph (b)(3) of this section. Accordingly, the amountcontributed to the fund is not required to be capital-ized under this section. While the amount serves toprotect the business reputation of the taxpayer and mayprotect the taxpayer from litigation by shareholders,these benefits, without more, are not intangible as-sets for which capitalization is required under this sec-tion unless the Internal Revenue Service publishesguidance identifying these benefits as an intangible as-set for which capitalization is required.

February 3, 2003 395 2003–5 I.R.B.

(m) Amortization. For rules relating toamortization of certain intangible assets, see§ 1.167(a)–3.

(n) Intangible interests in land. [Re-served].

(o) Effective Date — (1) In general. Thissection applies to amounts paid or incurredon or after the date the final regulations arepublished in the Federal Register.

(2) Automatic consent to change methodof accounting. A taxpayer seeking to changea method of accounting to comply with thissection must follow the applicable admin-istrative procedures issued under § 1.446–1(e)(3)(ii) for obtaining the Commissioner’sautomatic consent to a change in account-ing method (Revenue Procedure 2002–9 orits successor). Any change in method of ac-counting to comply with this section mustbe made using an adjustment under sec-tion 481(a). However, for this purpose, theadjustment under section 481(a) is deter-mined by taking into account only amountspaid or incurred on or after the date the fi-nal regulations are published in the Fed-eral Register. The final regulations mayprovide additional terms and conditions forchanges under this paragraph (o)(2).

Par. 4. Section 1.446–5 is added to readas follows:

§ 1.446–5 Debt issuance costs.

(a) In general. This section providesrules for allocating debt issuance costs overthe term of the debt. For purposes of thissection, the term debt issuance costs meansthose transaction costs incurred by an is-suer of debt (that is, a borrower) that arerequired to be capitalized under § 1.263(a)–4(e). If these costs are otherwise deduct-ible, they are deductible by the issuer overthe term of the debt as determined underparagraph (b) of this section.

(b) Method of allocating debt issuancecosts — (1) In general. Solely for pur-poses of determining the amount of debt is-suance costs that may be deducted in anyperiod, these costs are treated as if they ad-justed the yield on the debt. To effect this,the issuer treats the costs as if they de-creased the issue price of the debt. See§ 1.1273–2 to determine issue price. Thus,debt issuance costs increase or create origi-nal issuance discount and decrease or elimi-nate bond issuance premium.

(2) Original issue discount. Any result-ing original issue discount is taken into ac-

count by the issuer under the rules in§ 1.163–7, which generally require the useof a constant yield method (as described in§ 1.1272–1) to compute how much origi-nal issue discount is deductible for a pe-riod. However, see § 1.163–7(b) for specialrules that apply if the total original issue dis-count on the debt is de minimis.

(3) Bond issuance premium. Any re-maining bond issuance premium is takeninto account by the issuer under the rulesof § 1.163–13, which generally require theuse of a constant yield method for pur-poses of allocating bond issuance premiumto accrual periods.

(c) Example. The following example il-lustrates the rules of this section:

Example. (i) On January 1, 2004, X borrows$10,000,000. The principal amount of the loan($10,000,000) is repayable on December 31, 2008, andpayments of interest in the amount of $500,000 aredue on December 31 of each year the loan is out-standing. X incurs debt issuance costs of $130,000 tofacilitate the borrowing.

(ii) Under § 1.1273–2, the issue price of the loanis $10,000,000. However, under paragraph (b) of thissection, X reduces the issue price of the loan by thedebt issuance costs of $130,000, resulting in an is-sue price of $9,870,000. As a result, X treats the loanas 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). Be-cause this amount of original issue discount is morethan a de minimis amount (within the meaning of§ 1.1273–1(d)), X must allocate the original issue dis-count to each year based on the constant yield methoddescribed in § 1.1272–1(b). See § 1.163–7(a). Basedon this method and a yield of 5.30%, compounded an-nually, the original issue discount is allocable to eachyear as follows: $23,385 for 2004, $24,625 for 2005,$25,931 for 2006, $27,306 for 2007, and $28,753 for2008.

(d) Effective date. This section appliesto debt issuance costs incurred for debt in-struments issued on or after the date finalregulations are published in the FederalRegister.

(e) Accounting method changes — (1)Consent to change. An issuer required tochange its method of accounting for debtissuance costs to comply with this sec-tion must secure the consent of the Com-missioner in accordance with therequirements of § 1.446–1(e). Paragraph(e)(2) of this section provides the Com-missioner’s automatic consent for certainchanges.

(2) Automatic consent. The Commis-sioner grants consent for an issuer to changeits method of accounting for debt issu-ance costs incurred for debt instruments is-sued on or after the date final regulations

are published in the Federal Register. Be-cause this change is made on a cut-off ba-sis, no items of income or deduction areomitted or duplicated and, therefore, no ad-justment under section 481 is allowed. Theconsent granted by this paragraph (e)(2) ap-plies provided—

(i) The change is made to comply withthis section;

(ii) The change is made for the first tax-able year for which the issuer must ac-count for debt issuance costs under thissection; and

(iii) The issuer attaches to its federal in-come tax return for the taxable year con-taining the change a statement that it haschanged its method of accounting under thissection.


Internal Revenue.


Correction to Rev. Proc.2003–7

Announcement 2003–4

PURPOSE

This announcement removes Section 7relating to the Paperwork Reduction Actfrom Rev. Proc. 2003–7, 2003–1 I.R.B. 233.That section was included in Rev. Proc.2003–7 by error.

EFFECTIVE DATE

This announcement is effective as ofJanuary 6, 2003, the effective date of pub-lication of Rev. Proc. 2003–7 in 2003–1I.R.B. 233.

EFFECT ON OTHER DOCUMENTS

Rev. Proc. 2003–7 is corrected.


The principal author of this announce-ment is Gerard Traficanti of the Office ofthe Associate Chief Counsel (International).

2003–5 I.R.B. 396 February 3, 2003

Regulations GoverningPractice Before the InternalRevenue Service

Announcement 2003–5

AGENCY: Office of the Secretary, Trea-sury.

ACTION: Advance notice of proposed rule-making.

SUMMARY: This document provides ad-vance notice of proposed rulemaking toamend the regulations governing practicebefore the Internal Revenue Service, whichappear in the Code of Federal Regula-tions and in pamphlet form as Treasury De-partment Circular No. 230, RegulationsGoverning the Practice of Attorneys, Cer-tified Public Accountants, Enrolled Agents,Enrolled Actuaries, and Appraisers beforethe Service. This document invites indi-viduals and organizations to submit com-ments on revising Circular No. 230 toaddress certain issues regarding standardsof practice of attorneys, certified public ac-countants, enrolled agents, enrolled actu-aries, and appraisers who representtaxpayers before the Service.

DATES: Submit comments on or beforeFebruary 18, 2003.

ADDRESSES: Send submissions to:CC:ITA:RU (REG–122380–02), room 5226,Internal Revenue Service, POB 7604, BenFranklin Station, Washington, DC 20044.Submissions may be hand delivered Mon-day through Friday between the hours of8 a.m. and 4 p.m. to: CC:ITA:RU (REG–122380–02), Courier’s Desk, Internal Rev-enue Service, 1111 Constitution AvenueNW, Washington, DC. Alternatively, per-sons may submit comments electronicallyvia the IRS Internet site at: www.irs.gov/regs.

FOR FURTHER INFORMATIONCONTACT: Concerning issues for com-ment, Richard Goldstein at (202) 622–7820 or Brinton T. Warren (202) 622–4940;concerning submissions of comments,LaNita Van Dyke, (202) 622–7180; (nottoll-free numbers).


Background

Section 330 of title 31 of the UnitedStates Code authorizes the Secretary of theTreasury to regulate the practice of repre-sentatives before the Treasury Departmentand, after notice and an opportunity for aproceeding, to suspend or disbar from prac-tice before the Treasury Department thoserepresentatives who are incompetent, dis-reputable, or who violate regulations pre-scribed under section 330. Pursuant tosection 330, the Secretary, in Circular No.230 (31 CFR part 10), published regula-tions that authorize the Director of Prac-tice to act upon applications for enrollmentto practice before the Service, to instituteproceedings for suspension or disbarmentfrom practice before the Service, to makeinquiries with respect to matters under theDirector’s jurisdiction, and to perform suchother duties as are necessary to carry outthese functions.

The regulations were most recentlyamended on July 26, 2002, (T.D. 9011,2002–33 I.R.B. 356 [67 FR 48760]) toclarify the general standards of practice be-fore the Service. In the preamble to thoseamendments to the regulations, the Trea-sury Department and the Service stated theirintention to issue a second notice of pro-posed rulemaking to re-propose amend-ments to regulations governing standards fortax shelter opinions. The Treasury Depart-ment and the Service also stated their in-tention to issue an advanced notice ofproposed rulemaking covering additionalnonshelter matters pertaining to practice be-fore the Service.

Contemporaneously with the efforts toaddress issues affecting practice, the Trea-sury Department and the Service are reor-ganizing the Office of the Director ofPractice to enhance its effectiveness. As partof the reorganization, the authority to su-pervise the Office of the Director of Prac-tice has been delegated to the Office of theSenior Counselor to the Commissioner. Theauthority to make the agency decision indisciplinary proceedings when decisions byAdministrative Law Judges are appealed hasalso been delegated to the Senior Counse-lor to the Commissioner. The Office of Se-nior Counselor to the Commissionerobserves an “ethical wall” ensuring that theofficial who makes the agency decision insuch disciplinary proceedings is not ex-

posed to these cases prematurely. Anotherstep in the reorganization is the possible re-naming of the Office of the Director ofPractice to the Office of Professional Re-sponsibility. It also is contemplated that theOffice of Senior Counselor to the Com-missioner will have a centralized role in theselection of the Director of Practice. TheTreasury Department and the Service areseeking public comment on this reorgani-zation.

Special Analyses

It has been determined that this advancenotice of proposed rulemaking is not a sig-nificant regulatory action as defined in EO12866.

Request for Comments

The Treasury Department and the Ser-vice invite comments on the following mat-ters.

Director of Practice

1. Whether § 10.1 should be revised torename the Director of Practice as the Di-rector of the Office of Professional Re-sponsibility.

2. Whether the authority to appoint theDirector of Practice should be delegated tothe office or person who supervises the Di-rector of Practice. If not, to whom shouldthe Secretary delegate the authority to ap-point the Director of Practice?

3. Whether the review of an Adminis-trative Law Judge’s decision under § 10.78should be delegated to the office or per-son who supervises the Director of Prac-tice. If not, to whom should the Secretarydelegate the authority under § 10.78 to re-view the Administrative Law Judge’s de-cision in disciplinary proceedings whenthese decisions are appealed.

Definition of Practice and Who MayPractice

1. Whether the definition of practice be-fore the Service and the definition of prac-titioner in § 10.2 should be modified tospecifically provide that return prepara-tion by an individual not described in§ 10.3(a) through (d) (“unenrolled returnpreparer”) is practice before the Service andthat an unenrolled return preparer is a prac-titioner under Circular 230.

2. Whether § 10.3(b) should be revisedto permit licensed accountants, and certi-

February 3, 2003 397 2003–5 I.R.B.

fied internal auditors, who are not certi-fied public accountants, to practice beforethe Service.

3. Whether § 10.7(c)(1)(viii) should berevised to authorize the Director of Prac-tice to modify the scope of limited prac-tice by unenrolled return preparers, withoutfurther amendment to the regulations.

4. Whether the regulations should spe-cifically provide the Director of Practicewith authority to determine eligibility forlimited practice by unenrolled return pre-parers under § 10.7(c)(1)(viii).

Enrolled Agents and Eligibility forEnrollment

1. Whether Enrolled Agents should beallowed to refer to themselves as “LicensedTax Professionals” or another specified des-ignation determined by the Service, in ad-dition to or instead of the Enrolled Agentdesignation, to more fully describe the na-ture of the professional services that theyprovide.

2. Whether the regulations should setforth specific examples of acceptable de-scriptions of an Enrolled Agent’s practicefor advertisements.

3. Whether the Director of Practiceshould be authorized to determine, with-out requiring further amendment of theregulations, standards for the continuingprofessional education requirements of En-rolled Agents.

Sanctions and Disciplinary Proceedings

1. Whether the regulations should beamended to authorize a practitioner and theDirector of Practice to enter into settle-

ment agreements, with such agreements en-forceable through the expedited proceduresof § 10.82.

2. Whether the definition in the regu-lations of disreputable conduct should beamended to specifically include the will-ful failure of a practitioner who is a pre-parer to sign a return.

3. Whether, in order to facilitate thetimely adjudication of disciplinary pro-ceedings instituted under § 10.60, the regu-lations should be amended to provide thatthe failure of a practitioner to answer acomplaint constitutes an automatic de-fault in the proceeding, subject to a show-ing of good cause.

4. Whether the regulations should beamended to provide the parties to a pro-ceeding instituted under § 10.60 the op-portunity to obtain discovery through meanssuch as interrogatories, requests for pro-duction of documents, and requests for ad-missions, in addition to depositions.Whether the regulations should define whatdiscovery should be permitted. Whether theregulations should place limits on discov-ery.

5. Whether the protection afforded in thecurrent regulation — that a party in a dis-ciplinary proceeding is entitled to presenthis case or defense by oral or documen-tary evidence, to submit rebuttal evidence,and to conduct such cross examination asmay be required for a full and true disclo-sure of the facts — is sufficient, or whetherchanges should be made to afford greaterprotection in a disciplinary proceeding, in-cluding the opportunity to question, in thepresence of the Administrative Law Judge,any person whose statement is offered bythe opposing party.

Contingent fees

1. Whether contingent fees should bepermitted in conjunction with a request fora private letter ruling or other prefilingdocument.

2. Whether the regulations should con-tinue to permit a practitioner to charge acontingent fee for preparing, or for any ad-vice rendered in connection with a posi-tion taken or to be taken on, an amendedreturn or claim for refund.

3. Whether the prohibition on contin-gent fees should be expanded to permit con-tingent fees only for amended returns orclaims for refund when the client’s tax-able income on the amended return or claimfor refund is less than $50,000 (or anotheramount determined with reference to fi-nancial need).

Confidentiality Agreements

1. Whether the regulations should pro-hibit practitioners from entering into agree-ments with clients that, in violation ofapplicable state professional rules or ap-plicable state law, restrict a practitioner fromproviding relevant tax advice to other simi-larly situated taxpayers.

2. Whether the regulations should pro-hibit, irrespective of applicable state pro-fessional rules or applicable state law, theagreements identified above.

Pamela F. Olson,Assistant Secretary for Tax Policy.


2003–5 I.R.B. 398 February 3, 2003

Definition of TermsRevenue rulings and revenue procedures(hereinafter referred to as“rulings”) thathave an effect on previous rulings use thefollowing defined terms to describe theeffect:

Amplified describes a situation whereno change is being made in a prior pub-lished position, but the prior position isbeing extended to apply to a variation ofthe fact situation set forth therein. Thus, ifan earlier ruling held that a principleapplied to A, and the new ruling holdsthat the same principle also applies to B,the earlier ruling is amplified. (Comparewith modified, below).

Clarified is used in those instanceswhere the language in a prior ruling isbeing made clear because the languagehas caused, or may cause, some confu-sion. It is not used where a position in aprior ruling is being changed.

Distinguished describes a situationwhere a ruling mentions a previouslypublished ruling and points out an essen-tial difference between them.

Modified is used where the substanceof a previously published position isbeing changed. Thus, if a prior rulingheld that a principle applied to A but notto B, and the new ruling holds that it

applies to both A and B, the prior rulingis modified because it corrects a pub-lished position. (Compare with amplifiedand clarified, above).

Obsoleted describes a previously pub-lished ruling that is not considered deter-minative with respect to future transac-tions. This term is most commonly usedin a ruling that lists previously publishedrulings that are obsoleted because ofchanges in law or regulations. A rulingmay also be obsoleted because the sub-stance has been included in regulationssubsequently adopted.

Revoked describes situations where theposition in the previously published rul-ing is not correct and the correct positionis being stated in the new ruling.

Superseded describes a situation wherethe new ruling does nothing more thanrestate the substance and situation of apreviously published ruling (or rulings).Thus, the term is used to republish underthe 1986 Code and regulations the sameposition published under the 1939 Codeand regulations. The term is also usedwhen it is desired to republish in a singleruling a series of situations, names, etc.,that were previously published over aperiod of time in separate rulings. If the

new ruling does more than restate thesubstance of a prior ruling, a combinationof terms is used. For example, modifiedand superseded describes a situationwhere the substance of a previously pub-lished ruling is being changed in part andis continued without change in part and itis desired to restate the valid portion ofthe previously published ruling in a newruling that is self contained. In this case,the previously published ruling is firstmodified and then, as modified, is super-seded.

Supplemented is used in situations inwhich a list, such as a list of the names ofcountries, is published in a ruling and thatlist is expanded by adding further namesin subsequent rulings. After the originalruling has been supplemented severaltimes, a new ruling may be published thatincludes the list in the original ruling andthe additions, and supersedes all prior rul-ings in the series.

Suspended is used in rare situations toshow that the previous published rulingswill not be applied pending some futureaction such as the issuance of new oramended regulations, the outcome ofcases in litigation, or the outcome of aService study.

AbbreviationsThe following abbreviations in currentuse and formerly used will appear inmaterial published in the Bulletin.

A—Individual.Acq.—Acquiescence.B—Individual.BE—Beneficiary.BK—Bank.B.T.A.—Board of Tax Appeals.C—Individual.C.B.—Cumulative Bulletin.CFR—Code of Federal Regulations.CI—City.COOP—Cooperative.Ct.D.—Court Decision.CY—County.D—Decedent.DC—Dummy Corporation.DE—Donee.Del. Order—Delegation Order.DISC—Domestic International Sales Corporation.DR—Donor.E—Estate.EE—Employee.

E.O.—Executive Order.ER—Employer.ERISA—Employee Retirement Income Security Act.EX—Executor.F—Fiduciary.FC—Foreign Country.FICA—Federal Insurance Contributions Act.FISC—Foreign International Sales Company.FPH—Foreign Personal Holding Company.F.R.—Federal Register.FUTA—Federal Unemployment Tax Act.FX—Foreign Corporation.G.C.M.—Chief Counsel’s Memorandum.GE—Grantee.GP—General Partner.GR—Grantor.IC—Insurance Company.I.R.B.—Internal Revenue Bulletin.LE—Lessee.LP—Limited Partner.LR—Lessor.M—Minor.Nonacq.—Nonacquiescence.O—Organization.P—Parent Corporation.PHC—Personal Holding Company.

PO—Possession of the U.S.PR—Partner.PRS—Partnership.PTE—Prohibited Transaction Exemption.Pub. L.—Public Law.REIT—Real Estate Investment Trust.Rev. Proc.—Revenue Procedure.Rev. Rul.—Revenue Ruling.S—Subsidiary.S.P.R.—Statements of Procedural Rules.Stat.—Statutes at Large.T—Target Corporation.T.C.—Tax Court.T.D.—Treasury Decision.TFE—Transferee.TFR—Transferor.T.I.R.—Technical Information Release.TP—Taxpayer.TR—Trust.TT—Trustee.U.S.C.—United States Code.X—Corporation.Y—Corporation.Z—Corporation.

February 3, 2003 i 2003–5 I.R.B.

Numerical Finding List1

Bulletins 2003–1 through 2003–4

Announcements:

2003–1, 2003–2 I.R.B. 2812003–2, 2003–3 I.R.B. 3012003–3, 2003–4 I.R.B. 361

Notices:

2003–1, 2003–2 I.R.B. 2572003–2, 2003–2 I.R.B. 2572003–3, 2003–2 I.R.B. 2582003–4, 2003–3 I.R.B. 2942003–5, 2003–3 I.R.B. 2942003–6, 2003–3 I.R.B. 2982003–7, 2003–4 I.R.B. 3102003–8, 2003–4 I.R.B. 310

Proposed Regulations:

REG–209500–86, 2003–2 I.R.B. 262REG–151043–02, 2003–3 I.R.B. 300REG–164464–02, 2003–2 I.R.B. 262

Revenue Procedures:

2003–1, 2003–1, I.R.B. 12003–2, 2003–1, I.R.B. 762003–3, 2003–1, I.R.B. 1132003–4, 2003–1, I.R.B. 1232003–5, 2003–1, I.R.B. 1632003–6, 2003–1, I.R.B. 1912003–7, 2003–1, I.R.B. 2332003–8, 2003–1, I.R.B. 2362003–10, 2003–2 I.R.B. 2592003–11, 2003–4 I.R.B. 3112003–12, 2003–4 I.R.B. 3162003–13, 2003–4 I.R.B. 3172003–14, 2003–4 I.R.B. 3192003–15, 2003–4 I.R.B. 3212003–16, 2003–4 I.R.B. 359

Revenue Rulings:

2003–1, 2003–3 I.R.B. 2912003–2, 2003–2 I.R.B. 2512003–3, 2003–3 I.R.B. 2522003–4, 2003–4 I.R.B. 2532003–5, 2003–5 I.R.B. 2542003–6, 2003–3 I.R.B. 2862003–8, 2003–3 I.R.B. 2902003–9, 2003–4 I.R.B. 3032003–10, 2003–3 I.R.B. 2882003–11, 2003–3 I.R.B. 2852003–12, 2003–3 I.R.B. 2832003–13, 2003–4 I.R.B. 3052003–14, 2003–4 I.R.B. 3022003–15, 2003–4 I.R.B. 302

1 A cumulative list of all revenue rulings, revenue

procedures, Treasury decisions, etc., published in

Internal Revenue Bulletins 2002–26 through 2002–52 is

in Internal Revenue Bulletin 2003–1, dated January 6, 2003.

2003–5 I.R.B. ii February 3, 2003

Finding List of Current Actionson Previously Published Items2

Bulletins 2003–1 through 2003–4

Notices:

97–19Modified byRev. Proc. 2003–1, 2003–1 I.R.B. 1

2001–46Modified byNotice 2003–6, 2003–3 I.R.B. 298

2001–69Modified and superseded byNotice 2003–1, 2003–2 I.R.B. 257

2002–27Clarified byNotice 2003–3, 2003–2 I.R.B. 258

Revenue Procedures:


93–38Obsoleted byRev. Proc. 2003–15, 2003–4 I.R.B. 321

2002–1Superseded byRev. Proc. 2003–1, 2003–1 I.R.B. 1








2002–9Modified and amplified byRev. Rul. 2003–3, 2003–2 I.R.B. 252

Revenue Procedures—Continued:




2002–67Supplemented byAnn. 2003–3, 2003–4 I.R.B. 361


2003–3Amplified byRev. Proc. 2003–14, 2003–4 I.R.B. 319

Revenue Rulings:

53–131Modified byRev. Rul. 2003–12, 2003–3 I.R.B. 283

65–190Revoked byRev. Rul. 2003–3, 2003–2 I.R.B. 252

69–372Revoked byRev. Rul. 2003–3, 2003–2 I.R.B. 252

2 A cumulative list of current actions on previously

published items in Internal Revenue Bulletins

2002–26 through 2002–52 is in Internal Revenue

Bulletin 2003–1, dated January 6, 2003.

February 3, 2003 iii 2003–5 I.R.B.

INDEXInternal Revenue Bulletins2003–1 through 2003–4

The abbreviation and number in paren-thesis following the index entry refer tothe specific item; numbers in roman anditalic type following the parenthesis referto the Internal Revenue Bulletin in whichthe item may be found and the page num-ber on which it appears.

Key to Abbreviations:Ann AnnouncementCD Court DecisionDO Delegation OrderEO Executive OrderPL Public LawPTE Prohibited Transaction

ExemptionRP Revenue ProcedureRR Revenue RulingSPR Statement of Procedural

RulesTC Tax ConventionTD Treasury DecisionTDO Treasury Department Order

EMPLOYEE PLANSAdvance letter rulings and determination

letters, areas which will not be issuedfrom:Associates Chief Counsel and Division

Counsel/Associate Chief Counsel(TE/GE) (RP 3) 1, 113

Associate Chief Counsel (Interna-tional) (RP 7) 1, 233

Defined benefit plans, required minimumdistributions (Notice 2) 2, 257

Determination letters, issuing procedures(RP 6) 1, 191

Employee stock ownership plans, delayedeffective date, abuse (RR 6) 3, 286

Full funding limitations, weighted aver-age interest rate for:January 2003 (Notice 7) 4, 310

Individual retirement arrangements:Deemed IRAs (RP 13) 4, 317Required minimum distributions

(Notice 3) 2, 258

EMPLOYEE PLANS—Cont.Letter rulings:

Determination letters and informationletters issued by Associates ChiefCounsel and Division Counsel/Associate Chief Counsel (TE/GE)(RP 1) 1, 1

Information letters, etc. (RP 4) 1, 123Limitation on annual compensation, non-

discrimination (RR 11) 3, 285Nondiscrimination, governmental plans

(Notice 6) 3, 298Proposed Regulations:

26 CFR 1.401(a)(4)–3, –9, revised;1.411(b)–2, revised; reductions ofaccruals and allocations because ofthe attainment of any age; applica-tion of nondiscrimination cross-testing rules to cash balance plans(REG–209500–86, REG–164464–02) 2, 262

Qualified retirement plans:Age discrimination (REG–209500–86,

REG–164464–02) 2, 262Distributions, rollover, waiver of

60-day requirement (RP 16) 4, 359Minimum distributions, delayed

amendment date (RP 10) 2, 259Technical advice:

Proposed cash balance regulations, agediscrimination issues (Ann 1) 2, 281

To directors and chiefs, appealsoffices, from Associates ChiefCounsel and Division Counsel/Associate Chief Counsel (TE/GE)(RP 2) 1, 76

To IRS employees (RP 5) 1, 163User fees, request for letter rulings (RP 8)

1, 236

EXEMPTORGANIZATIONSAdvance letter rulings and determination

letters, areas which will not be issuedfrom Associates Chief Counsel andDivision Counsel/Associate ChiefCounsel (TE/GE) (RP 3) 1, 113

Dissolution clause requirements for sec-tion 501(c)(3) entities seeking a section115(1) letter ruling (RP 12) 4, 316

EXEMPTORGANIZATIONS—Cont.Letter rulings:

Determination letters and informationletters issued by Associates ChiefCounsel and Division Counsel/Associate Chief Counsel (TE/GE)(RP 1) 1, 1

Information letters, etc. (RP 4) 1, 123Private foundations, termination, transfer

of assets (RR 13) 4, 305Technical advice to:

Directors and chiefs, appeals offices,from Associates Chief Counsel andDivision Counsel/Associate ChiefCounsel (TE/GE) (RP 2) 1, 76

IRS employees (RP 5) 1, 163User fees, request for letter rulings (RP 8)

1, 236

INCOME TAXAccrual of income (RR 10) 3, 288Advance letter rulings and determination

letters, areas which will not be issuedfrom:Associates Chief Counsel and Division

Counsel/Associate Chief Counsel(TE/GE) (RP 3) 1, 113

Associate Chief Counsel (Interna-tional) (RP 7) 1, 233

Constructive sales treatment for appreci-ated financial positions (RR 1) 3, 291

Contingent liability transaction cases, listof arbitrators (Ann 3) 4, 361

Corporations:Foreign tax credit limitation, dividends

from a noncontrolled section 902corporation (Notice 5) 3, 294

Transactions involving deemed sale ofcorporate assets under section 338,new Form 8883 (Ann 2) 3, 301

Cost-share payments, Agricultural Man-agement Assistance Program (AMA)(RR 15) 4, 302

Costa Rican withholding taxes, noncredit-ability (RR 8) 3, 290

Credits:Low-income housing credit:

Satisfactory bond, “bond factor”amounts for the period:January through March 2003 (RR

2) 2, 251

2003–5 I.R.B. iv February 3, 2003

INCOME TAX—Cont.Forms: 8883, Asset Allocation Statement

Under Section 338, new (Ann 2) 3, 301Information reporting on Form 1099–B

for securities futures contracts (Notice8) 4, 310

Insurance companies, recomputed differ-ential earnings rate for 2000 and thedifferential earnings rate for 2001 formutual life insurance companies (RR 4)2, 253

Interest:Investment:

Federal short-term, mid-term, andlong-term rates for:January 2003 (RR 5) 2, 254

Inventory:LIFO, price indexes used by depart-

ment stores for:November 2002 (RR 9) 4, 303

Leave-based donation programs (Notice1) 2, 257

Letter rulings, determination letters andinformation letters issued by AssociatesChief Counsel and Division Counsel/Associate Chief Counsel (TE/GE) (RP1) 1, 1

LIFO recapture installment payments(Notice 4) 3, 294

Offshore Voluntary Compliance Initiative(RP 11) 4, 311

Presidentially declared disaster, grossincome, disaster relief payments (RR12) 3, 283

Proposed Regulations:26 CFR 1.61–8, revised; rents and roy-

alties (REG–151043–02) 3, 300Qualified census tracts, issuers of quali-

fied mortgage bonds and mortgagecredit certificates (RP 15) 4, 321

Rents and royalties, inclusion of advancerentals in gross income (REG–151043–02) 3, 300

Soil and Water Conservation AssistanceProgram (SWCA) (RR 14) 4, 302

State tax refunds, accrual of income (RR3) 2, 252

Technical advice to:Directors and chiefs, appeals offices,

from Associates Chief Counsel andDivison Counsel/Associate ChiefCounsel (TE/GE) (RP 2) 1, 76

IRS employees (RP 5) 1, 163Trusts for minors, Indian Gaming Regula-

tory Act (IGRA) (RP 14) 4, 319

February 3, 2003 v 2003–5 I.R.B.60068/496-919�� 3�