[Code of Federal Regulations]
[Title 26, Volume 1]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.263(a)-4]

[Page 424-446]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.263(a)-4  Amounts paid to acquire or create intangibles.

    (a) Overview. This section provides rules for applying section 
263(a) to amounts paid to acquire or create intangibles. Except to the 
extent provided in paragraph (d)(8) of this section, the rules provided 
by this section do not apply to amounts paid to acquire or create 
tangible assets. Paragraph (b) of this section provides a general 
principle of capitalization. Paragraphs (c) and (d) of this section 
identify intangibles for which capitalization is specifically required 
under the general principle. Paragraph (e) of this section provides 
rules for determining the extent to which taxpayers must capitalize 
transaction costs. Paragraph (f) of this section provides a 12-month 
rule intended to simplify the application of the general principle to 
certain payments that create benefits of a brief duration. Additional 
rules and examples relating to these provisions are provided in 
paragraphs (g) through (n) of this section. The applicability date of 
the rules in this section is provided in paragraph (o) of this section. 
Paragraph (p) of this section provides rules applicable to changes in 
methods of accounting made to comply with this section.
    (b) Capitalization with respect to intangibles--(1) In general. 
Except as otherwise provided in this section, a taxpayer must 
capitalize--
    (i) An amount paid to acquire an intangible (see paragraph (c) of 
this section);
    (ii) An amount paid to create an intangible described in paragraph 
(d) of this section;
    (iii) An amount paid to create or enhance a separate and distinct 
intangible asset within the meaning of paragraph (b)(3) of this section;
    (iv) An amount paid to create or enhance a future benefit identified 
in published guidance in the Federal Register or in the Internal Revenue 
Bulletin (see Sec. 601.601(d)(2)(ii) of this chapter) as an intangible 
for which capitalization is required under this section; and
    (v) An amount paid to facilitate (within the meaning of paragraph 
(e)(1) of this section) an acquisition or creation of an intangible 
described in paragraph (b)(1)(i), (ii), (iii) or (iv) of this section.
    (2) Published guidance. Any published guidance identifying a future 
benefit as an intangible for which capitalization is required under 
paragraph (b)(1)(iv) of this section applies only to amounts paid on or 
after the date of publication of the guidance.
    (3) Separate and distinct intangible asset--(i) Definition. The term 
separate and distinct intangible asset means a property interest of 
ascertainable and measurable value in money's worth that is subject to 
protection under applicable State, Federal or foreign law and the 
possession and control of which is intrinsically capable of being sold, 
transferred or pledged (ignoring any restrictions imposed on 
assignability) separate and apart from a trade or business. In addition, 
for purposes of this section, a fund (or similar account) is treated as 
a separate and distinct intangible asset of the taxpayer if amounts in 
the fund (or account) may revert to the taxpayer. The determination of 
whether a payment creates a separate and distinct intangible asset is 
made based on all of the facts and circumstances existing during the 
taxable year in which the payment is made.

[[Page 425]]

    (ii) Creation or termination of contract rights. Amounts paid to 
another party to create, originate, enter into, renew or renegotiate an 
agreement with that party that produces rights or benefits for the 
taxpayer (and amounts paid to facilitate the creation, origination, 
enhancement, renewal or renegotiation of such an agreement) are treated 
as amounts that do not create (or facilitate the creation of) a separate 
and distinct intangible asset within the meaning of this paragraph 
(b)(3). Further, amounts paid to another party to terminate (or 
facilitate the termination of) an agreement with that party are treated 
as amounts that do not create a separate and distinct intangible asset 
within the meaning of this paragraph (b)(3). See paragraphs (d)(2), 
(d)(6), and (d)(7) of this section for rules that specifically require 
capitalization of amounts paid to create or terminate certain 
agreements.
    (iii) Amounts paid in performing services. Amounts paid in 
performing services under an agreement are treated as amounts that do 
not create a separate and distinct intangible asset within the meaning 
of this paragraph (b)(3), regardless of whether the amounts result in 
the creation of an income stream under the agreement.
    (iv) Creation of computer software. Except as otherwise provided in 
the Internal Revenue Code, the regulations thereunder, or other 
published guidance in the Federal Register or in the Internal Revenue 
Bulletin (see Sec. 601.601(d)(2)(ii) of this chapter), amounts paid to 
develop computer software are treated as amounts that do not create a 
separate and distinct intangible asset within the meaning of this 
paragraph (b)(3).
    (v) Creation of package design. Amounts paid to develop a package 
design are treated as amounts that do not create a separate and distinct 
intangible asset within the meaning of this paragraph (b)(3). For 
purposes of this section, the term package design means the specific 
graphic arrangement or design of shapes, colors, words, pictures, 
lettering, and other elements on a given product package, or the design 
of a container with respect to its shape or function.
    (4) Coordination with other provisions of the Internal Revenue 
Code--(i) In general. Nothing in this section changes the treatment of 
an amount that is specifically provided for under any other provision of 
the Internal Revenue Code (other than section 162(a) or 212) or the 
regulations thereunder.
    (ii) Example. The following example illustrates the rule of this 
paragraph (b)(4):

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

    (c) Acquired intangibles--(1) In general. A taxpayer must capitalize 
amounts paid to another party to acquire any intangible from that party 
in a purchase or similar transaction. Examples of intangibles within the 
scope of this paragraph (c) include, but are not limited to, the 
following (if acquired from another party in a purchase or similar 
transaction):
    (i) An ownership interest in a corporation, partnership, trust, 
estate, limited liability company, or other entity.
    (ii) A debt instrument, deposit, stripped bond, stripped coupon 
(including a servicing right treated for federal income tax purposes as 
a stripped coupon), regular interest in a REMIC or FASIT, or any other 
intangible treated as debt for federal income tax purposes.
    (iii) A financial instrument, such as--
    (A) A notional principal contract;
    (B) A foreign currency contract;
    (C) A futures contract;
    (D) A forward contract (including an agreement under which the 
taxpayer has the right and obligation to provide or to acquire property 
(or to be compensated for such property, regardless

[[Page 426]]

of whether the taxpayer provides or acquires the property));
    (E) An option (including an agreement under which the taxpayer has 
the right to provide or to acquire property (or to be compensated for 
such property, regardless of whether the taxpayer provides or acquires 
the property)); and
    (F) Any other financial derivative.
    (iv) An endowment contract, annuity contract, or insurance contract.
    (v) Non-functional currency.
    (vi) A lease.
    (vii) A patent or copyright.
    (viii) A franchise, trademark or tradename (as defined in Sec. 
1.197-2(b)(10)).
    (ix) An assembled workforce (as defined in Sec. 1.197-2(b)(3)).
    (x) Goodwill (as defined in Sec. 1.197-2(b)(1)) or going concern 
value (as defined in Sec. 1.197-2(b)(2)).
    (xi) A customer list.
    (xii) A servicing right (for example, a mortgage servicing right 
that is not treated for Federal income tax purposes as a stripped 
coupon).
    (xiii) A customer-based intangible (as defined in Sec. 1.197-
2(b)(6)) or supplier-based intangible (as defined in Sec. 1.197-
2(b)(7)).
    (xiv) Computer software.
    (xv) An agreement providing either party the right to use, possess 
or sell an intangible described in paragraphs (c)(1)(i) through (v) of 
this section.
    (2) Readily available software. An amount paid to obtain a 
nonexclusive license for software that is (or has been) readily 
available to the general public on similar terms and has not been 
substantially modified (within the meaning of Sec. 1.197-2(c)(4)) is 
treated for purposes of this paragraph (c) as an amount paid to another 
party to acquire an intangible from that party in a purchase or similar 
transaction.
    (3) Intangibles acquired from an employee. Amounts paid to an 
employee to acquire an intangible from that employee are not required to 
be capitalized under this section if the amounts are includible in the 
employee's income in connection with the performance of services under 
section 61 or 83. For purposes of this section, whether an individual is 
an employee is determined in accordance with the rules contained in 
section 3401(c) and the regulations thereunder.
    (4) Examples. The following examples illustrate the rules of this 
paragraph (c):

    Example 1. Debt instrument. X corporation, a commercial bank, 
purchases a portfolio of existing loans from Y corporation, another 
financial institution. X pays Y $2,000,000 in exchange for the 
portfolio. The $2,000,000 paid to Y constitutes an amount paid to 
acquire an intangible from Y and must be capitalized.
    Example 2. Option. W corporation owns all of the outstanding stock 
of X corporation. Y corporation holds a call option entitling it to 
purchase from W all of the outstanding stock of X at a certain price per 
share. Z corporation acquires the call option from Y in exchange for 
$5,000,000. The $5,000,000 paid to Y constitutes an amount paid to 
acquire an intangible from Y and must be capitalized.
    Example 3. Ownership interest in a corporation. Same as Example 2, 
but assume Z exercises its option and purchases from W all of the 
outstanding stock of X in exchange for $100,000,000. The $100,000,000 
paid to W constitutes an amount paid to acquire an intangible from W and 
must be capitalized.
    Example 4. Customer list. N corporation, a retailer, sells its 
products through its catalog and mail order system. N purchases a 
customer list from R corporation. N pays R $100,000 in exchange for the 
customer list. The $100,000 paid to R constitutes an amount paid to 
acquire an intangible from R and must be capitalized.
    Example 5. Goodwill. Z corporation pays W corporation $10,000,000 to 
purchase all of the assets of W in a transaction that constitutes an 
applicable asset acquisition under section 1060(c). Of the $10,000,000 
consideration paid in the transaction, $9,000,000 is allocable to 
tangible assets purchased from W and $1,000,000 is allocable to 
goodwill. The $1,000,000 allocable to goodwill constitutes an amount 
paid to W to acquire an intangible from W and must be capitalized.

    (d) Created intangibles--(1) In general. Except as provided in 
paragraph (f) of this section (relating to the 12-month rule), a 
taxpayer must capitalize amounts paid to create an intangible described 
in this paragraph (d). The determination of whether an amount is paid to 
create an intangible described in this paragraph (d) is to be made based 
on all of the facts and circumstances, disregarding distinctions between 
the labels used in this paragraph (d) to describe the intangible and the 
labels used by the taxpayer and other parties to the transaction.

[[Page 427]]

    (2) Financial interests--(i) In general. A taxpayer must capitalize 
amounts paid to another party to create, originate, enter into, renew or 
renegotiate with that party any of the following financial interests, 
whether or not the interest is regularly traded on an established 
market:
    (A) An ownership interest in a corporation, partnership, trust, 
estate, limited liability company, or other entity.
    (B) A debt instrument, deposit, stripped bond, stripped coupon 
(including a servicing right treated for federal income tax purposes as 
a stripped coupon), regular interest in a REMIC or FASIT, or any other 
intangible treated as debt for Federal income tax purposes.
    (C) A financial instrument, such as--
    (1) A letter of credit;
    (2) A credit card agreement;
    (3) A notional principal contract;
    (4) A foreign currency contract;
    (5) A futures contract;
    (6) A forward contract (including an agreement under which the 
taxpayer has the right and obligation to provide or to acquire property 
(or to be compensated for such property, regardless of whether the 
taxpayer provides or acquires the property));
    (7) An option (including an agreement under which the taxpayer has 
the right to provide or to acquire property (or to be compensated for 
such property, regardless of whether the taxpayer provides or acquires 
the property)); and
    (8) Any other financial derivative.
    (D) An endowment contract, annuity contract, or insurance contract 
that has or may have cash value.
    (E) Non-functional currency.
    (F) An agreement providing either party the right to use, possess or 
sell a financial interest described in this paragraph (d)(2).
    (ii) Amounts paid to create, originate, enter into, renew or 
renegotiate. An amount paid to another party is not paid to create, 
originate, enter into, renew or renegotiate a financial interest with 
that party if the payment is made with the mere hope or expectation of 
developing or maintaining a business relationship with that party and is 
not contingent on the origination, renewal or renegotiation of a 
financial interest with that party.
    (iii) Renegotiate. A taxpayer is treated as renegotiating a 
financial interest if the terms of the financial interest are modified. 
A taxpayer also is treated as renegotiating a financial interest if the 
taxpayer enters into a new financial interest with the same party (or 
substantially the same parties) to a terminated financial interest, the 
taxpayer could not cancel the terminated financial interest without the 
consent of the other party (or parties), and the other party (or 
parties) would not have consented to the cancellation unless the 
taxpayer entered into the new financial interest. A taxpayer is treated 
as unable to cancel a financial interest without the consent of the 
other party (or parties) if, under the terms of the financial interest, 
the taxpayer is subject to a termination penalty and the other party (or 
parties) to the financial interest modifies the terms of the penalty.
    (iv) Coordination with other provisions of this paragraph (d). An 
amount described in this paragraph (d)(2) that is also described 
elsewhere in paragraph (d) of this section is treated as described only 
in this paragraph (d)(2).
    (v) Coordination with Sec. 1.263(a)-5. See Sec. 1.263(a)-5 for the 
treatment of borrowing costs and the treatment of amounts paid by an 
option writer.
    (vi) Examples. The following examples illustrate the rules of this 
paragraph (d)(2):

    Example 1. Loan. X corporation, a commercial bank, makes a loan to A 
in the principal amount of $250,000. The $250,000 principal amount of 
the loan paid to A constitutes an amount paid to another party to create 
a debt instrument with that party under paragraph (d)(2)(i)(B) of this 
section and must be capitalized.
    Example 2. Option. W corporation owns all of the outstanding stock 
of X corporation. Y corporation pays W $1,000,000 in exchange for W's 
grant of a 3-year call option to Y permitting Y to purchase all of the 
outstanding stock of X at a certain price per share. Y's payment of 
$1,000,000 to W constitutes an amount paid to another party to create an 
option with that party under paragraph (d)(2)(i)(C)(7) of this section 
and must be capitalized.
    Example 3. Partnership interest. Z corporation pays $10,000 to P, a 
partnership, in exchange for an ownership interest in P. Z's

[[Page 428]]

payment of $10,000 to P constitutes an amount paid to another party to 
create an ownership interest in a partnership with that party under 
paragraph (d)(2)(i)(A) of this section and must be capitalized.
    Example 4. Take or pay contract. Q corporation, a producer of 
natural gas, pays $1,000,000 to R during 2005 to induce R corporation to 
enter into a 5-year ``take or pay'' gas purchase contract. Under the 
contract, R is liable to pay for a specified minimum amount of gas, 
whether or not R takes such gas. Q's payment of $1,000,000 is an amount 
paid to another party to induce that party to enter into an agreement 
providing Q the right and obligation to provide property or be 
compensated for such property (regardless of whether the property is 
provided) under paragraph (d)(2)(i)(C)(6) of this section and must be 
capitalized.
    Example 5.. Agreement to provide property. P corporation pays R 
corporation $1,000,000 in exchange for R's agreement to purchase 1,000 
units of P's product at any time within the three succeeding calendar 
years. The agreement describes P's $1,000,000 as a sales discount. P's 
$1,000,000 payment is an amount paid to induce R to enter into an 
agreement providing P the right and obligation to provide property under 
paragraph (d)(2)(i)(C)(6) of this section and must be capitalized.
    Example 6. Customer incentive payment. S corporation, a computer 
manufacturer, seeks to develop a business relationship with V 
corporation, a computer retailer. As an incentive to encourage V to 
purchase computers from S, S enters into an agreement with V under which 
S agrees that, if V purchases $20,000,000 of computers from S within 3 
years from the date of the agreement, S will pay V $2,000,000 on the 
date that V reaches the $20,000,000 threshold. V reaches the $20,000,000 
threshold during the third year of the agreement, and S pays V 
$2,000,000. S is not required to capitalize its payment to V under this 
paragraph (d)(2) because the payment does not provide S the right or 
obligation to provide property and does not create a separate and 
distinct intangible asset for S within the meaning of paragraph 
(b)(3)(i) of this section.

    (3) Prepaid expenses--(i) In general. A taxpayer must capitalize 
prepaid expenses.
    (ii) Examples. The following examples illustrate the rules of this 
paragraph (d)(3):

    Example 1. Prepaid insurance. N corporation, an accrual method 
taxpayer, pays $10,000 to an insurer to obtain three years of coverage 
under a property and casualty insurance policy. The $10,000 is a prepaid 
expense and must be capitalized under this paragraph (d)(3). Paragraph 
(d)(2) of this section does not apply to the payment because the policy 
has no cash value.
    Example 2. Prepaid rent. X corporation, a cash method taxpayer, 
enters into a 24-month lease of office space. At the time of the lease 
signing, X prepays $240,000. No other amounts are due under the lease. 
The $240,000 is a prepaid expense and must be capitalized under this 
paragraph (d)(3).

    (4) Certain memberships and privileges--(i) In general. A taxpayer 
must capitalize amounts paid to an organization to obtain, renew, 
renegotiate, or upgrade a membership or privilege from that 
organization. A taxpayer is not required to capitalize under this 
paragraph (d)(4) an amount paid to obtain, renew, renegotiate or upgrade 
certification of the taxpayer's products, services, or business 
processes.
    (ii) Examples. The following examples illustrate the rules of this 
paragraph (d)(4):

    Example 1. Hospital privilege. B, a physician, pays $10,000 to Y 
corporation to obtain lifetime staff privileges at a hospital operated 
by Y. B must capitalize the $10,000 payment under this paragraph (d)(4).
    Example 2. Initiation fee. X corporation pays a $50,000 initiation 
fee to obtain membership in a trade association. X must capitalize the 
$50,000 payment under this paragraph (d)(4).
    Example 3. Product rating. V corporation, an automobile 
manufacturer, pays W corporation, a national quality ratings 
association, $100,000 to conduct a study and provide a rating of the 
quality and safety of a line of V's automobiles. V's payment is an 
amount paid to obtain a certification of V's product and is not required 
to be capitalized under this paragraph (d)(4).
    Example 4. Business process certification. Z corporation, a 
manufacturer, seeks to obtain a certification that its quality control 
standards meet a series of international standards known as ISO 9000. Z 
pays $50,000 to an independent registrar to obtain a certification from 
the registrar that Z's quality management system conforms to the ISO 
9000 standard. Z's payment is an amount paid to obtain a certification 
of Z's business processes and is not required to be capitalized under 
this paragraph (d)(4).

    (5) Certain rights obtained from a governmental agency--(i) In 
general. A taxpayer must capitalize amounts paid to a governmental 
agency to obtain, renew, renegotiate, or upgrade its rights under a 
trademark, trade name, copyright, license, permit, franchise, or other 
similar right granted by that governmental agency.

[[Page 429]]

    (ii) Examples. The following examples illustrate the rules of this 
paragraph (d)(5):

    Example 1. Business license. X corporation pays $15,000 to state Y 
to obtain a business license that is valid indefinitely. Under this 
paragraph (d)(5), the amount paid to state Y is an amount paid to a 
government agency for a right granted by that agency. Accordingly, X 
must capitalize the $15,000 payment.
    Example 2. Bar admission. A, an individual, pays $1,000 to an agency 
of state Z to obtain a license to practice law in state Z that is valid 
indefinitely, provided A adheres to the requirements governing the 
practice of law in state Z. Under this paragraph (d)(5), the amount paid 
to state Z is an amount paid to a government agency for a right granted 
by that agency. Accordingly, A must capitalize the $1,000 payment.

    (6) Certain contract rights--(i) In general. Except as otherwise 
provided in this paragraph (d)(6), a taxpayer must capitalize amounts 
paid to another party to create, originate, enter into, renew or 
renegotiate with that party--
    (A) An agreement providing the taxpayer the right to use tangible or 
intangible property or the right to be compensated for the use of 
tangible or intangible property;
    (B) An agreement providing the taxpayer the right to provide or to 
receive services (or the right to be compensated for services regardless 
of whether the taxpayer provides such services);
    (C) A covenant not to compete or an agreement having substantially 
the same effect as a covenant not to compete (except, in the case of an 
agreement that requires the performance of services, to the extent that 
the amount represents reasonable compensation for services actually 
rendered);
    (D) An agreement not to acquire additional ownership interests in 
the taxpayer; or
    (E) An agreement providing the taxpayer (as the covered party) with 
an annuity, an endowment, or insurance coverage.
    (ii) Amounts paid to create, originate, enter into, renew or 
renegotiate. An amount paid to another party is not paid to create, 
originate, enter into, renew or renegotiate an agreement with that party 
if the payment is made with the mere hope or expectation of developing 
or maintaining a business relationship with that party and is not 
contingent on the origination, renewal or renegotiation of an agreement 
with that party.
    (iii) Renegotiate. A taxpayer is treated as renegotiating an 
agreement if the terms of the agreement are modified. A taxpayer also is 
treated as renegotiating an agreement if the taxpayer enters into a new 
agreement with the same party (or substantially the same parties) to a 
terminated agreement, the taxpayer could not cancel the terminated 
agreement without the consent of the other party (or parties), and the 
other party (or parties) would not have consented to the cancellation 
unless the taxpayer entered into the new agreement. A taxpayer is 
treated as unable to cancel an agreement without the consent of the 
other party (or parties) if, under the terms of the agreement, the 
taxpayer is subject to a termination penalty and the other party (or 
parties) to the agreement modifies the terms of the penalty.
    (iv) Right. An agreement does not provide the taxpayer a right to 
use property or to provide or receive services if the agreement may be 
terminated at will by the other party (or parties) to the agreement 
before the end of the period prescribed by paragraph (f)(1) of this 
section. An agreement is not terminable at will if the other party (or 
parties) to the agreement is economically compelled not to terminate the 
agreement until the end of the period prescribed by paragraph (f)(1) of 
this section. All of the facts and circumstances will be considered in 
determining whether the other party (or parties) to an agreement is 
economically compelled not to terminate the agreement. An agreement also 
does not provide the taxpayer the right to provide services if the 
agreement merely provides that the taxpayer will stand ready to provide 
services if requested, but places no obligation on another person to 
request or pay for the taxpayer's services.
    (v) De minimis amounts. A taxpayer is not required to capitalize 
amounts paid to another party (or parties) to create, originate, enter 
into, renew or renegotiate with that party (or those parties) an 
agreement described in paragraph (d)(6)(i) of this section if the 
aggregate

[[Page 430]]

of all amounts paid to that party (or those parties) with respect to the 
agreement does not exceed $5,000. If the aggregate of all amounts paid 
to the other party (or parties) with respect to that agreement exceeds 
$5,000, then all amounts must be capitalized. For purposes of this 
paragraph (d)(6), an amount paid in the form of property is valued at 
its fair market value at the time of the payment. In general, a taxpayer 
must determine whether the rules of this paragraph (d)(6)(v) apply by 
accounting for the specific amounts paid with respect to each agreement. 
However, a taxpayer that reasonably expects to create, originate, enter 
into, renew or renegotiate at least 25 similar agreements during the 
taxable year may establish a pool of agreements for purposes of 
determining the amounts paid with respect to the agreements in the pool. 
Under this pooling method, the amount paid with respect to each 
agreement included in the pool is equal to the average amount paid with 
respect to all agreements included in the pool. A taxpayer computes the 
average amount paid with respect to all agreements included in the pool 
by dividing the sum of all amounts paid with respect to all agreements 
included in the pool by the number of agreements included in the pool. 
See paragraph (h) of this section for additional rules relating to 
pooling.
    (vi) Exception for lessee construction allowances. Paragraph 
(d)(6)(i) of this section does not apply to amounts paid by a lessor to 
a lessee as a construction allowance to the extent the lessee expends 
the amount for the tangible property that is owned by the lessor for 
Federal income tax purposes (see, for example, section 110).
    (vii) Examples. The following examples illustrate the rules of this 
paragraph (d)(6):

    Example 1. New lease agreement. V seeks to lease commercial property 
in a prominent downtown location of city R. V pays Z, the owner of the 
commercial property, $50,000 in exchange for Z entering into a 10-year 
lease with V. V's payment is an amount paid to another party to enter 
into an agreement providing V the right to use tangible property. 
Because the $50,000 payment exceeds $5,000, no portion of the amount 
paid to Z is de minimis for purposes of paragraph (d)(6)(v) of this 
section. Under paragraph (d)(6)(i)(A) of this section, V must capitalize 
the entire $50,000 payment.
    Example 2. Modification of lease agreement. Partnership Y leases a 
piece of equipment for use in its business from Z corporation. When the 
lease has a remaining term of 3 years, Y requests that Z modify the 
existing lease by extending the remaining term by 5 years. Y pays 
$50,000 to Z in exchange for Z's agreement to modify the existing lease. 
Y's payment of $50,000 is an amount paid to another party to renegotiate 
an agreement providing Y the right to use property. Because the $50,000 
payment exceeds $5,000, no portion of the amount paid to Z is de minimis 
for purposes of paragraph (d)(6)(v) of this section. Under paragraph 
(d)(6)(i)(A) of this section, Y must capitalize the entire $50,000 
payment.
    Example 3. Modification of lease agreement. In 2004, R enters into a 
5-year, non-cancelable lease of a mainframe computer for use in its 
business. R subsequently determines that the mainframe computer that R 
is leasing is no longer adequate for its needs. In 2006, R and P 
corporation (the lessor) agree to terminate the 2004 lease and to enter 
into a new 5-year lease for a different and more powerful mainframe 
computer. R pays P a $75,000 early termination fee. P would not have 
agreed to terminate the 2004 lease unless R agreed to enter into the 
2006 lease. R's payment of $75,000 is an amount paid to another party to 
renegotiate an agreement providing R the right to use property. Because 
the $75,000 payment exceeds $5,000, no portion of the amount paid to P 
is de minimis for purposes of paragraph (d)(6)(v) of this section. Under 
paragraph (d)(6)(i)(A) of this section, R must capitalize the entire 
$75,000 payment.
    Example 4. Modification of lease agreement. Same as Example 3, 
except the 2004 lease agreement allows R to terminate the lease at any 
time subject to a $75,000 early termination fee. Because R can terminate 
the lease without P's approval, R's payment of $75,000 is not an amount 
paid to another party to renegotiate an agreement. Accordingly, R is not 
required to capitalize the $75,000 payment under this paragraph (d)(6).
    Example 5. Modification of lease agreement. Same as Example 4, 
except P agreed to reduce the early termination fee to $60,000. Because 
R did not pay an amount to renegotiate the early termination fee, R's 
payment of $60,000 is not an amount paid to another party to renegotiate 
an agreement. Accordingly, R is not required to capitalize the $60,000 
payment under this paragraph (d)(6).
    Example 6. Covenant not to compete. R corporation enters into an 
agreement with A, an individual, that prohibits A from competing with R 
for a period of three years. To encourage A to enter into the agreement, 
R agrees to pay A $100,000 upon the signing of the agreement. R's 
payment is an amount

[[Page 431]]

paid to another party to enter into a covenant not to compete. Because 
the $100,000 payment exceeds $5,000, no portion of the amount paid to A 
is de minimis for purposes of paragraph (d)(6)(v) of this section. Under 
paragraph (d)(6)(i)(C) of this section, R must capitalize the entire 
$100,000 payment.
    Example 7. Standstill agreement. During 2004 through 2005, X 
corporation acquires a large minority interest in the stock of Z 
corporation. To ensure that X does not take control of Z, Z pays X 
$5,000,000 for a standstill agreement under which X agrees not to 
acquire any more stock in Z for a period of 10 years. Z's payment is an 
amount paid to another party to enter into an agreement not to acquire 
additional ownership interests in Z. Because the $5,000,000 payment 
exceeds $5,000, no portion of the amount paid to X is de minimis for 
purposes of paragraph (d)(6)(v) of this section. Under paragraph 
(d)(6)(i)(D) of this section, Z must capitalize the entire $5,000,000 
payment.
    Example 8. Signing bonus. Employer B pays a $25,000 signing bonus to 
employee C to induce C to come to work for B. C can leave B's employment 
at any time to work for a competitor of B and is not required to repay 
the $25,000 bonus to B. Because C is not economically compelled to 
continue his employment with B, B's payment does not provide B the right 
to receive services from C. Accordingly, B is not required to capitalize 
the $25,000 payment.
    Example 9. Renewal. In 2000, M corporation and N corporation enter 
into a 5-year agreement that gives M the right to manage N's investment 
portfolio. In 2005, N has the option of renewing the agreement for 
another three years. During 2004, M pays $10,000 to send several 
employees of N to an investment seminar. M pays the $10,000 to help 
develop and maintain its business relationship with N with the 
expectation that N will renew its agreement with M in 2005. Because M's 
payment is not contingent on N agreeing to renew the agreement, M's 
payment is not an amount paid to renew an agreement under paragraph 
(d)(6)(ii) of this section and is not required to be capitalized.
    Example 10. De minimis payments. X corporation is engaged in the 
business of providing wireless telecommunications services to customers. 
To induce customer B to enter into a 3-year non-cancelable 
telecommunications contract, X provides B with a free wireless 
telephone. The fair market value of the wireless telephone is $300 at 
the time it is provided to B. X's provision of a wireless telephone to B 
is an amount paid to B to induce B to enter into an agreement providing 
X the right to provide services, as described in paragraph (d)(6)(i)(B) 
of this section. Because the amount of the inducement is $300, the 
amount of the inducement is de minimis under paragraph (d)(6)(v) of this 
section. Accordingly, X is not required to capitalize the amount of the 
inducement provided to B.

    (7) Certain contract terminations--(i) In general. A taxpayer must 
capitalize amounts paid to another party to terminate--
    (A) A lease of real or tangible personal property between the 
taxpayer (as lessor) and that party (as lessee);
    (B) An agreement that grants that party the exclusive right to 
acquire or use the taxpayer's property or services or to conduct the 
taxpayer's business (other than an intangible described in paragraph 
(c)(1)(i) through (iv) of this section or a financial interest described 
in paragraph (d)(2) of this section); or
    (C) An agreement that prohibits the taxpayer from competing with 
that party or from acquiring property or services from a competitor of 
that party.
    (ii) Certain break-up fees. Paragraph (d)(7)(i) of this section does 
not apply to the termination of a transaction described in Sec. 
1.263(a)-5(a) (relating to an acquisition of a trade or business, a 
change in the capital structure of a business entity, and certain other 
transactions). See Sec. 1.263(a)-5(c)(8) for rules governing the 
treatment of amounts paid to terminate a transaction to which that 
section applies.
    (iii) Examples. The following examples illustrate the rules of this 
paragraph (d)(7):

    Example 1. Termination of exclusive license agreement. On July 1, 
2005, N enters into a license agreement with R corporation under which N 
grants R the exclusive right to manufacture and distribute goods using 
N's design and trademarks for a period of 10 years. On June 30, 2007, N 
pays R $5,000,000 in exchange for R's agreement to terminate the 
exclusive license agreement. N's payment to terminate its license 
agreement with R constitutes a payment to terminate an exclusive license 
to use the taxpayer's property, as described in paragraph (d)(7)(i)(B) 
of this section. Accordingly, N must capitalize its $5,000,000 payment 
to R.
    Example 2. Termination of exclusive distribution agreement. On March 
1, 2005, L, a manufacturer, enters into an agreement with M granting M 
the right to be the sole distributor of L's products in state X for 10 
years. On July 1, 2008, L pays M $50,000 in exchange for M's agreement 
to terminate the distribution agreement. L's payment to terminate its 
agreement with M constitutes a

[[Page 432]]

payment to terminate an exclusive right to acquire L's property, as 
described in paragraph (d)(7)(i)(B) of this section. Accordingly, L must 
capitalize its $50,000 payment to M.
    Example 3. Termination of covenant not to compete. On February 1, 
2005, Y corporation enters into a covenant not to compete with Z 
corporation that prohibits Y from competing with Z in city V for a 
period of 5 years. On January 31, 2007, Y pays Z $1,000,000 in exchange 
for Z's agreement to terminate the covenant not to compete. Y's payment 
to terminate the covenant not to compete with Z constitutes a payment to 
terminate an agreement that prohibits Y from competing with Z, as 
described in paragraph (d)(7)(i)(C) of this section. Accordingly, Y must 
capitalize its $1,000,000 payment to Z.
    Example 4. Termination of merger agreement. N corporation and U 
corporation enter into an agreement under which N agrees to merge into 
U. Subsequently, N pays U $10,000,000 to terminate the merger agreement. 
As provided in paragraph (d)(7)(ii) of this section, N's $10,000,000 
payment to terminate the merger agreement with U is not required to be 
capitalized under this paragraph (d)(7). In addition, N's $10,000,000 
does not create a separate and distinct intangible asset for N within 
the meaning of paragraph (b)(3)(i) of this section. (See Sec. 1.263(a)-
5 for additional rules regarding termination of merger agreements).

    (8) Certain benefits arising from the provision, production, or 
improvement of real property--(i) In general. A taxpayer must capitalize 
amounts paid for real property if the taxpayer transfers ownership of 
the real property to another person (except to the extent the real 
property is sold for fair market value) and if the real property can 
reasonably be expected to produce significant economic benefits to the 
taxpayer after the transfer. A taxpayer also must capitalize amounts 
paid to produce or improve real property owned by another (except to the 
extent the taxpayer is selling services at fair market value to produce 
or improve the real property) if the real property can reasonably be 
expected to produce significant economic benefits for the taxpayer.
    (ii) Exclusions. A taxpayer is not required to capitalize an amount 
under paragraph (d)(8)(i) of this section if the taxpayer transfers real 
property or pays an amount to produce or improve real property owned by 
another in exchange for services, the purchase or use of property, or 
the creation of an intangible described in paragraph (d) of this section 
(other than in this paragraph (d)(8)). The preceding sentence does not 
apply to the extent the taxpayer does not receive fair market value 
consideration for the real property that is relinquished or for the 
amounts that are paid by the taxpayer to produce or improve real 
property owned by another.
    (iii) Real property. For purposes of this paragraph (d)(8), real 
property includes property that is affixed to real property and that 
will ordinarily remain affixed for an indefinite period of time, such as 
roads, bridges, tunnels, pavements, wharves and docks, breakwaters and 
sea walls, elevators, power generation and transmission facilities, and 
pollution control facilities.
    (iv) Impact fees and dedicated improvements. Paragraph (d)(8)(i) of 
this section does not apply to amounts paid to satisfy one-time charges 
imposed by a State or local government against new development (or 
expansion of existing development) to finance specific offsite capital 
improvements for general public use that are necessitated by the new or 
expanded development. In addition, paragraph (d)(8)(i) of this section 
does not apply to amounts paid for real property or improvements to real 
property constructed by the taxpayer where the real property or 
improvements benefit new development or expansion of existing 
development, are immediately transferred to a State or local government 
for dedication to the general public use, and are maintained by the 
State or local government. See section 263A and the regulations 
thereunder for capitalization rules that apply to amounts referred to in 
this paragraph (d)(8)(iv).
    (v) Examples. The following examples illustrate the rules of this 
paragraph (d)(8):

    Example 1. Amount paid to produce real property owned by another. W 
corporation operates a quarry on the east side of a river in city Z and 
a crusher on the west side of the river. City Z's existing bridges are 
of insufficient capacity to be traveled by trucks in transferring stone 
from W's quarry to its crusher. As a result, the efficiency of W's 
operations is greatly reduced. W contributes $1,000,000 to city Z to 
defray in part the cost of constructing a publicly owned bridge capable 
of accommodating W's trucks. W's payment to city Z is an amount paid to 
produce

[[Page 433]]

or improve real property (within the meaning of paragraph (d)(8)(iii) of 
this section) that can reasonably be expected to produce significant 
economic benefits for W. Under paragraph (d)(8)(i) of this section, W 
must capitalize the $1,000,000 paid to city Z.
    Example 2. Transfer of real property to another. K corporation, a 
shipping company, uses smaller vessels to unload its ocean-going vessels 
at port X. There is no natural harbor at port X, and during stormy 
weather the transfer of freight between K's ocean vessels and port X is 
extremely difficult and sometimes impossible, which can be very costly 
to K. Consequently, K constructs a short breakwater at a cost of 
$50,000. The short breakwater, however, is inadequate, so K persuades 
the port authority to build a larger breakwater that will allow K to 
unload its vessels at any time of the year and during all kinds of 
weather. K contributes the short breakwater and pays $200,000 to the 
port authority for use in building the larger breakwater. Because the 
transfer of the small breakwater and $200,000 is reasonably expected to 
produce significant economic benefits for K, K must capitalize both the 
adjusted basis of the small breakwater (determined at the time the small 
breakwater is contributed) and the $200,000 payment under this paragraph 
(d)(8).
    Example 3. Dedicated improvements. X corporation is engaged in the 
development and sale of residential real estate. In connection with a 
residential real estate project under construction by X in city Z, X is 
required by city Z to construct ingress and egress roads to and from its 
project and immediately transfer the roads to city Z for dedication to 
general public use. The roads will be maintained by city Z. X pays its 
subcontractor $100,000 to construct the ingress and egress roads. X's 
payment is a dedicated improvement within the meaning of paragraph 
(d)(8)(iv) of this section. Accordingly, X is not required to capitalize 
the $100,000 payment under this paragraph (d)(8). See section 263A and 
the regulations thereunder for capitalization rules that apply to 
amounts referred to in paragraph (d)(8)(iv) of this section.

    (9) Defense or perfection of title to intangible property--(i) In 
general. A taxpayer must capitalize amounts paid to another party to 
defend or perfect title to intangible property if that other party 
challenges the taxpayer's title to the intangible property.
    (ii) Certain break-up fees. Paragraph (d)(9)(i) of this section does 
not apply to the termination of a transaction described in Sec. 
1.263(a)-5(a) (relating to an acquisition of a trade or business, a 
change in the capital structure of a business entity, and certain other 
transactions). See Sec. 1.263(a)-5 for rules governing the treatment of 
amounts paid to terminate a transaction to which that section applies. 
Paragraph (d)(9)(i) of this section also does not apply to an amount 
paid to another party to terminate an agreement that grants that party 
the right to purchase the taxpayer's intangible property.
    (iii) Example. The following example illustrates the rules of this 
paragraph (d)(9):

    Example. Defense of title. R corporation claims to own an exclusive 
patent on a particular technology. U corporation brings a lawsuit 
against R, claiming that U is the true owner of the patent and that R 
stole the technology from U. The sole issue in the suit involves the 
validity of R's patent. R chooses to settle the suit by paying U 
$100,000 in exchange for U's release of all future claim to the patent. 
R's payment to U is an amount paid to defend or perfect title to 
intangible property under paragraph (d)(9) of this section and must be 
capitalized.

    (e) Transaction costs--(1) Scope of facilitate--(i) In general. 
Except as otherwise provided in this section, an amount is paid to 
facilitate the acquisition or creation of an intangible (the 
transaction) if the amount is paid in the process of investigating or 
otherwise pursuing the transaction. Whether an amount is paid in the 
process of investigating or otherwise pursuing the transaction is 
determined based on all of the facts and circumstances. In determining 
whether an amount is paid to facilitate a transaction, the fact that the 
amount would (or would not) have been paid but for the transaction is 
relevant, but is not determinative. An amount paid to determine the 
value or price of an intangible is an amount paid in the process of 
investigating or otherwise pursuing the transaction.
    (ii) Treatment of termination payments. An amount paid to terminate 
(or acilitate the termination of) an existing agreement does not 
facilitate the acquisition or creation of another agreement under this 
section. See paragraph (d)(6)(iii) of this section for the treatment of 
termination fees paid to the other party (or parties) of a renegotiated 
agreement.
    (iii) Special rule for contracts. An amount is treated as not paid 
in the process of investigating or otherwise

[[Page 434]]

pursuing the creation of an agreement described in paragraph (d)(2) or 
(d)(6) of this section if the amount relates to activities performed 
before the earlier of the date the taxpayer begins preparing its bid for 
the agreement or the date the taxpayer begins discussing or negotiating 
the agreement with another party to the agreement.
    (iv) Borrowing costs. An amount paid to facilitate a borrowing does 
not facilitate an acquisition or creation of an intangible described in 
paragraphs (b)(1)(i) through (iv) of this section. See Sec. Sec. 
1.263(a)-5 and 1.446-5 for the treatment of an amount paid to facilitate 
a borrowing.
    (v) Special rule for stock redemption costs of open-end regulated 
investment companies. An amount paid by an open-end regulated investment 
company (within the meaning of section 851) to facilitate a redemption 
of its stock is treated as an amount that does not facilitate the 
acquisition of an intangible under this section.
    (2) Coordination with paragraph (d) of this section. In the case of 
an amount paid to facilitate the creation of an intangible described in 
paragraph (d) of this section, the provisions of this paragraph (e) 
apply regardless of whether a payment described in paragraph (d) is 
made.
    (3) Transaction. For purposes of this section, the term transaction 
means all of the factual elements comprising an acquisition or creation 
of an intangible and includes a series of steps carried out as part of a 
single plan. Thus, a transaction can involve more than one invoice and 
more than one intangible. For example, a purchase of intangibles under 
one purchase agreement constitutes a single transaction, notwithstanding 
the fact that the acquisition involves multiple intangibles and the 
amounts paid to facilitate the acquisition are capable of being 
allocated among the various intangibles acquired.
    (4) Simplifying conventions--(i) In general. For purposes of this 
section, employee compensation (within the meaning of paragraph 
(e)(4)(ii) of this section), overhead, and de minimis costs (within the 
meaning of paragraph (e)(4)(iii) of this section) are treated as amounts 
that do not facilitate the acquisition or creation of an intangible.
    (ii) Employee compensation--(A) In general. The term employee 
compensation means compensation (including salary, bonuses and 
commissions) paid to an employee of the taxpayer. For purposes of this 
section, whether an individual is an employee is determined in 
accordance with the rules contained in section 3401(c) and the 
regulations thereunder.
    (B) Certain amounts treated as employee compensation. For purposes 
of this section, a guaranteed payment to a partner in a partnership is 
treated as employee compensation. For purposes of this section, annual 
compensation paid to a director of a corporation is treated as employee 
compensation. For example, an amount paid to a director of a corporation 
for attendance at a regular meeting of the board of directors (or 
committee thereof) is treated as employee compensation for purposes of 
this section. However, an amount paid to a director for attendance at a 
special meeting of the board of directors (or committee thereof) is not 
treated as employee compensation. An amount paid to a person that is not 
an employee of the taxpayer (including the employer of the individual 
who performs the services) is treated as employee compensation for 
purposes of this section only if the amount is paid for secretarial, 
clerical, or similar administrative support services. In the case of an 
affiliated group of corporations filing a consolidated Federal income 
tax return, a payment by one member of the group to a second member of 
the group for services performed by an employee of the second member is 
treated as employee compensation if the services provided by the 
employee are provided at a time during which both members are 
affiliated.
    (iii) De minimis costs--(A) In general. Except as provided in 
paragraph (e)(4)(iii)(B) of this section, the term de minimis costs 
means amounts (other than employee compensation and overhead) paid in 
the process of investigating or otherwise pursuing a transaction if, in 
the aggregate, the amounts do not exceed $5,000 (or such greater amount 
as may be set forth in

[[Page 435]]

published guidance). If the amounts exceed $5,000 (or such greater 
amount as may be set forth in published guidance), none of the amounts 
are de minimis costs within the meaning of this paragraph 
(e)(4)(iii)(A). For purposes of this paragraph (e)(4)(iii), an amount 
paid in the form of property is valued at its fair market value at the 
time of the payment. In determining the amount of transaction costs paid 
in the process of investigating or otherwise pursuing a transaction, a 
taxpayer generally must account for the specific costs paid with respect 
to each transaction. However, a taxpayer that reasonably expects to 
enter into at least 25 similar transactions during the taxable year may 
establish a pool of similar transactions for purposes of determining the 
amount of transaction costs paid in the process of investigating or 
otherwise pursuing the transactions in the pool. Under this pooling 
method, the amount of transaction costs paid in the process of 
investigating or otherwise pursuing each transaction included in the 
pool is equal to the average transaction costs paid in the process of 
investigating or otherwise pursuing all transactions included in the 
pool. A taxpayer computes the average transaction costs paid in the 
process of investigating or otherwise pursuing all transactions included 
in the pool by dividing the sum of all transaction costs paid in the 
process of investigating or otherwise pursuing all transactions included 
in the pool by the number of transactions included in the pool. See 
paragraph (h) of this section for additional rules relating to pooling.
    (B) Treatment of commissions. The term de minimis costs does not 
include commissions paid to facilitate the acquisition of an intangible 
described in paragraphs (c)(1)(i) through (v) of this section or to 
facilitate the creation, origination, entrance into, renewal or 
renegotiation of an intangible described in paragraph (d)(2)(i) of this 
section.
    (iv) Election to capitalize. A taxpayer may elect to treat employee 
compensation, overhead, or de minimis costs paid in the process of 
investigating or otherwise pursuing a transaction as amounts that 
facilitate the transaction. The election is made separately for each 
transaction and applies to employee compensation, overhead, or de 
minimis costs, or to any combination thereof. For example, a taxpayer 
may elect to treat overhead and de minimis costs, but not employee 
compensation, as amounts that facilitate the transaction. A taxpayer 
makes the election by treating the amounts to which the election applies 
as amounts that facilitate the transaction in the taxpayer's timely 
filed original Federal income tax return (including extensions) for the 
taxable year during which the amounts are paid. In the case of an 
affiliated group of corporations filing a consolidated return, the 
election is made separately with respect to each member of the group, 
and not with respect to the group as a whole. In the case of an S 
corporation or partnership, the election is made by the S corporation or 
by the partnership, and not by the shareholders or partners. An election 
made under this paragraph (e)(4)(iv) is revocable with respect to each 
taxable year for which made only with the consent of the Commissioner.
    (5) Examples. The following examples illustrate the rules of this 
paragraph (e):

    Example 1. Costs to facilitate. In December 2005, R corporation, a 
calendar year taxpayer, enters into negotiations with X corporation to 
lease commercial property from X for a period of 25 years. R pays A, its 
outside legal counsel, $4,000 in December 2005 for services rendered by 
A during December in assisting with negotiations with X. In January 
2006, R and X finalize the terms of the lease and execute the lease 
agreement. R pays B, another of its outside legal counsel, $2,000 in 
January 2006 for services rendered by B during January in drafting the 
lease agreement. The agreement between R and X is an agreement providing 
R the right to use property, as described in paragraph (d)(6)(i)(A) of 
this section. R's payments to its outside counsel are amounts paid to 
facilitate the creation of the agreement. As provided in paragraph 
(e)(4)(iii)(A) of this section, R must aggregate its transaction costs 
for purposes of determining whether the transaction costs are de 
minimis. Because R's aggregate transaction costs exceed $5,000, R's 
transaction costs are not de minimis costs within the meaning of 
paragraph (e)(4)(iii)(A) of this section. Accordingly, R must capitalize 
the $4,000 paid to A and the $2,000 paid to B under paragraph (b)(1)(v) 
of this section.

[[Page 436]]

    Example 2. Costs to facilitate. Partnership X leases its 
manufacturing equipment from Y corporation under a 10-year lease. During 
2005, when the lease has a remaining term of 4 years, X enters into a 
written agreement with Z corporation, a competitor of Y, under which X 
agrees to lease its manufacturing equipment from Z, subject to the 
condition that X first successfully terminates its lease with Y. X pays 
Y $50,000 in exchange for Y's agreement to terminate the equipment 
lease. Under paragraph (e)(1)(ii), X's $50,000 payment does not 
facilitate the creation of the new lease with Z. In addition, X's 
$50,000 payment does not terminate an agreement described in paragraph 
(d)(7) of this section. Accordingly, X is not required to capitalize the 
$50,000 termination payment under this section.
    Example 3. Costs to facilitate. W corporation enters into a lease 
agreement with X corporation under which W agrees to lease property to X 
for a period of 5 years. W pays its outside counsel $7,000 for legal 
services rendered in drafting the lease agreement and negotiating with 
X. The agreement between W and X is an agreement providing W the right 
to be compensated for the use of property, as described in paragraph 
(d)(6)(i)(A) of this section. Under paragraph (e)(1)(i) of this section, 
W's payment to its outside counsel is an amount paid to facilitate the 
creation of that agreement. As provided by paragraph (e)(2) of this 
section, W must capitalize its $7,000 payment to outside counsel 
notwithstanding the fact that W made no payment described in paragraph 
(d)(6)(i) of this section.
    Example 4. Costs to facilitate. U corporation, which owns a majority 
of the common stock of T corporation, votes its controlling interest in 
favor of a perpetual extension of T's charter. M, a minority shareholder 
in T, votes against the extension. Under applicable state law, U is 
required to purchase the stock of T held by M. When U and M are unable 
to agree on the value of M's shares, U brings an action in state court 
to appraise the value of M's stock interest. U pays attorney, accountant 
and appraisal fees of $25,000 for services rendered in connection with 
the negotiation and litigation with M. Because U's attorney, accountant 
and appraisal costs help establish the purchase price of M's stock, U's 
$25,000 payment facilitates the acquisition of stock. Accordingly, U 
must capitalize the $25,000 payment under paragraph (b)(1)(v) of this 
section.
    Example 5. Costs to facilitate. For several years, H corporation has 
provided services to J corporation whenever requested by J. H wants to 
enter into a multiple-year contract with J that would give H the right 
to provide services to J. On June 10, 2004, H starts to prepare a bid to 
provide services to J and pays a consultant $15,000 to research 
potential competitors. On August 10, 2004, H raises the possibility of a 
multi-year contract with J. On October 10, 2004, H and J enter into a 
contract giving H the right to provide services to J for five years. 
During 2004, H pays $7,000 to travel to the city in which J's offices 
are located to continue providing services to J under their prior 
arrangement and pays $6,000 for travel to the city in which J's offices 
are located to further develop H's business relationship with J (for 
example, to introduce new employees, update J on current developments 
and take J's executives to dinner). H also pays $8,000 for travel costs 
to meet with J to discuss and negotiate the contract. Because the 
contract gives H the right to provide services to J, H must capitalize 
amounts paid to facilitate the creation of the contract. The $7,000 of 
travel expenses paid to provide services to J under their prior 
arrangement does not facilitate the creation of the contract and is not 
required to be capitalized, regardless of when the travel occurs. The 
$6,000 of travel expenses paid to further develop H's business 
relationship with J is paid in the process of pursuing the contract (and 
therefore must be capitalized) only to the extent the expenses relate to 
travel on or after June 10, 2004 (the date H begins to prepare a bid) 
and before October 11, 2004 (the date after H and J enter into the 
contract). The $8,000 of travel expenses paid to meet with J to discuss 
and negotiate the contract is paid in the process of pursuing the 
contact and must be capitalized. The $15,000 of consultant fees is paid 
to investigate the contract and also must be capitalized.
    Example 6. Costs that do not facilitate. X corporation brings a 
legal action against Y corporation to recover lost profits resulting 
from Y's alleged infringement of X's copyright. Y does not challenge X's 
copyright, but argues that it did not infringe upon X's copyright. X 
pays its outside counsel $25,000 for legal services rendered in pursuing 
the suit against Y. Because X's title to its copyright is not in 
question, X's action against Y does not involve X's defense or 
perfection of title to intangible property. Thus, the amount paid to 
outside counsel does not facilitate the creation of an intangible 
described in paragraph (d)(9) of this section. Accordingly, X is not 
required to capitalize its $25,000 payment under this section.
    Example 7. De minimis rule. W corporation, a commercial bank, 
acquires a portfolio containing 100 loans from Y corporation. As part of 
the acquisition, W pays an independent appraiser a fee of $10,000 to 
appraise the portfolio. The fee is an amount paid to facilitate W's 
acquisition of an intangible. The acquisition of the loan portfolio is a 
single transaction within the meaning of paragraph (e)(3) of this 
section. Because the amount paid to facilitate the transaction exceeds

[[Page 437]]

$5,000, the amount is not de minimis as defined in paragraph 
(e)(4)(iii)(A) of this section. Accordingly, W must capitalize the 
$10,000 fee under paragraph (b)(1)(v) of this section.
    Example 8. Compensation and overhead. P corporation, a commercial 
bank, maintains a loan acquisition department whose sole function is to 
acquire loans from other financial institutions. As provided in 
paragraph (e)(4)(i) of this section, P is not required to capitalize any 
portion of the compensation paid to the employees in its loan 
acquisition department or any portion of its overhead allocable to the 
loan acquisition department.
    (f) 12-month rule--(1) In general. Except as otherwise provided in 
this paragraph (f), a taxpayer is not required to capitalize under this 
section amounts paid to create (or to facilitate the creation of) any 
right or benefit for the taxpayer that does not extend beyond the 
earlier of--
    (i) 12 months after the first date on which the taxpayer realizes 
the right or benefit; or
    (ii) The end of the taxable year following the taxable year in which 
the payment is made.
    (2) Duration of benefit for contract terminations. For purposes of 
this paragraph (f), amounts paid to terminate a contract or other 
agreement described in paragraph (d)(7)(i) of this section prior to its 
expiration date (or amounts paid to facilitate such termination) create 
a benefit for the taxpayer that lasts for the unexpired term of the 
agreement immediately before the date of the termination. If the terms 
of a contract or other agreement described in paragraph (d)(7)(i) of 
this section permit the taxpayer to terminate the contract or agreement 
after a notice period, amounts paid by the taxpayer to terminate the 
contract or agreement before the end of the notice period create a 
benefit for the taxpayer that lasts for the amount of time by which the 
notice period is shortened.
    (3) Inapplicability to created financial interests and self-created 
amortizable section 197 intangibles. Paragraph (f)(1) of this section 
does not apply to amounts paid to create (or facilitate the creation of) 
an intangible described in paragraph (d)(2) of this section (relating to 
amounts paid to create financial interests) or to amounts paid to create 
(or facilitate the creation of) an intangible that constitutes an 
amortizable section 197 intangible within the meaning of section 197(c).
    (4) Inapplicability to rights of indefinite duration. Paragraph 
(f)(1) of this section does not apply to amounts paid to create (or 
facilitate the creation of) an intangible of indefinite duration. A 
right has an indefinite duration if it has no period of duration fixed 
by agreement or by law, or if it is not based on a period of time, such 
as a right attributable to an agreement to provide or receive a fixed 
amount of goods or services. For example, a license granted by a 
governmental agency that permits the taxpayer to operate a business 
conveys a right of indefinite duration if the license may be revoked 
only upon the taxpayer's violation of the terms of the license.
    (5) Rights subject to renewal--(i) In general. For purposes of 
paragraph (f)(1) of this section, the duration of a right includes any 
renewal period if all of the facts and circumstances in existence during 
the taxable year in which the right is created indicate a reasonable 
expectancy of renewal.
    (ii) Reasonable expectancy of renewal. The following factors are 
significant in determining whether there exists a reasonable expectancy 
of renewal:
    (A) Renewal history. The fact that similar rights are historically 
renewed is evidence of a reasonable expectancy of renewal. On the other 
hand, the fact that similar rights are rarely renewed is evidence of a 
lack of a reasonable expectancy of renewal. Where the taxpayer has no 
experience with similar rights, or where the taxpayer holds similar 
rights only occasionally, this factor is less indicative of a reasonable 
expectancy of renewal.
    (B) Economics of the transaction. The fact that renewal is necessary 
for the taxpayer to earn back its investment in the right is evidence of 
a reasonable expectancy of renewal. For example, if a taxpayer pays 
$14,000 to enter into a renewable contract with an initial 9-month term 
that is expected to generate income to the taxpayer of $1,000 per month, 
the fact that renewal is necessary for the taxpayer to earn back its 
$14,000 payment is evidence of a reasonable expectancy of renewal.

[[Page 438]]

    (C) Likelihood of renewal by other party. Evidence that indicates a 
likelihood of renewal by the other party to a right, such as a bargain 
renewal option or similar arrangement, is evidence of a reasonable 
expectancy of renewal. However, the mere fact that the other party will 
have the opportunity to renew on the same terms as are available to 
others is not evidence of a reasonable expectancy of renewal.
    (D) Terms of renewal. The fact that material terms of the right are 
subject to renegotiation at the end of the initial term is evidence of a 
lack of a reasonable expectancy of renewal. For example, if the parties 
to an agreement must renegotiate price or amount, the renegotiation 
requirement is evidence of a lack of a reasonable expectancy of renewal.
    (E) Terminations. The fact that similar rights are typically 
terminated prior to renewal is evidence of a lack of a reasonably 
expectancy of renewal.
    (iii) Safe harbor pooling method. In lieu of applying the reasonable 
expectancy of renewal test described in paragraph (f)(5)(ii) of this 
section to each separate right created during a taxable year, a taxpayer 
that reasonably expects to enter into at least 25 similar rights during 
the taxable year may establish a pool of similar rights for which the 
initial term does not extend beyond the period prescribed in paragraph 
(f)(1) of this section and may elect to apply the reasonable expectancy 
of renewal test to that pool. See paragraph (h) of this section for 
additional rules relating to pooling. The application of paragraph 
(f)(1) of this section to each pool is determined in the following 
manner:
    (A) All amounts (except de minimis costs described in paragraph 
(d)(6)(v) of this section) paid to create the rights included in the 
pool and all amounts paid to facilitate the creation of the rights 
included in the pool are aggregated.
    (B) If less than 20 percent of the rights in the pool are reasonably 
expected to be renewed beyond the period prescribed in paragraph (f)(1) 
of this section, all rights in the pool are treated as having a duration 
that does not extend beyond the period prescribed in paragraph (f)(1) of 
this section, and the taxpayer is not required to capitalize under this 
section any portion of the aggregate amount described in paragraph 
(f)(5)(iii)(A) of this section.
    (C) If more than 80 percent of the rights in the pool are reasonably 
expected to be renewed beyond the period prescribed in paragraph (f)(1) 
of this section, all rights in the pool are treated as having a duration 
that extends beyond the period prescribed in paragraph (f)(1) of this 
section, and the taxpayer is required to capitalize under this section 
the aggregate amount described in paragraph (f)(5)(iii)(A) of this 
section.
    (D) If 20 percent or more, but 80 percent or less, of the rights in 
the pool are reasonably expected to be renewed beyond the period 
prescribed in paragraph (f)(1) of this section, the aggregate amount 
described in paragraph (f)(5)(iii)(A) of this section is multiplied by 
the percentage of the rights in the pool that are reasonably expected to 
be renewed beyond the period prescribed in paragraph (f)(1) of this 
section and the taxpayer must capitalize the resulting amount under this 
section by treating such amount as creating a separate intangible. The 
amount determined by multiplying the aggregate amount described in 
paragraph (f)(5)(iii)(A) of this section by the percentage of rights in 
the pool that are not reasonably expected to be renewed beyond the 
period prescribed in paragraph (f)(1) of this section is not required to 
be capitalized under this section.
    (6) Coordination with section 461. In the case of a taxpayer using 
an accrual method of accounting, the rules of this paragraph (f) do not 
affect the determination of whether a liability is incurred during the 
taxable year, including the determination of whether economic 
performance has occurred with respect to the liability. See Sec. 1.461-
4 for rules relating to economic performance.
    (7) Election to capitalize. A taxpayer may elect not to apply the 
rule contained in paragraph (f)(1) of this section. An election made 
under this paragraph (f)(7) applies to all similar transactions during 
the taxable year to which paragraph (f)(1) of this section would apply 
(but for the election under

[[Page 439]]

this paragraph (f)(7)). For example, a taxpayer may elect under this 
paragraph (f)(7) to capitalize its costs of prepaying insurance 
contracts for 12 months, but may continue to apply the rule in paragraph 
(f)(1) to its costs of entering into non-renewable, 12-month service 
contracts. A taxpayer makes the election by treating the amounts as 
capital expenditures in its timely filed original federal income tax 
return (including extensions) for the taxable year during which the 
amounts are paid. In the case of an affiliated group of corporations 
filing a consolidated return, the election is made separately with 
respect to each member of the group, and not with respect to the group 
as a whole. In the case of an S corporation or partnership, the election 
is made by the S corporation or by the partnership, and not by the 
shareholders or partners. An election made under this paragraph (f)(7) 
is revocable with respect to each taxable year for which made only with 
the consent of the Commissioner.
    (8) Examples. The rules of this paragraph (f) are illustrated by the 
following examples, in which it is assumed (unless otherwise stated) 
that the taxpayer is a calendar year, accrual method taxpayer that does 
not have a short taxable year in any taxable year and has not made an 
election under paragraph (f)(7) of this section:

    Example 1. Prepaid expenses. On December 1, 2005, N corporation pays 
a $10,000 insurance premium to obtain a property insurance policy (with 
no cash value) with a 1-year term that begins on February 1, 2006. The 
amount paid by N is a prepaid expense described in paragraph (d)(3) of 
this section and not paragraph (d)(2) of this section. Because the right 
or benefit attributable to the $10,000 payment extends beyond the end of 
the taxable year following the taxable year in which the payment is 
made, the 12-month rule provided by this paragraph (f) does not apply. N 
must capitalize the $10,000 payment.
    Example 2. Prepaid expenses. (i) Assume the same facts as in Example 
1, except that the policy has a term beginning on December 15, 2005. The 
12-month rule of this paragraph (f) applies to the $10,000 payment 
because the right or benefit attributable to the payment neither extends 
more than 12 months beyond December 15, 2005 (the first date the benefit 
is realized by the taxpayer) nor beyond the end of the taxable year 
following the taxable year in which the payment is made. Accordingly, N 
is not required to capitalize the $10,000 payment.
    (ii) Alternatively, assume N capitalizes prepaid expenses for 
financial accounting and reporting purposes and elects under paragraph 
(f)(7) of this section not to apply the 12-month rule contained in 
paragraph (f)(1) of this section. N must capitalize the $10,000 payment 
for Federal income tax purposes.
    Example 3. Financial interests. On October 1, 2005, X corporation 
makes a 9-month loan to B in the principal amount of $250,000. The 
principal amount of the loan to B constitutes an amount paid to create 
or originate a financial interest under paragraph (d)(2)(i)(B) of this 
section. The 9-month term of the loan does not extend beyond the period 
prescribed by paragraph (f)(1) of this section. However, as provided by 
paragraph (f)(3) of this section, the rules of this paragraph (f) do not 
apply to intangibles described in paragraph (d)(2) of this section. 
Accordingly, X must capitalize the $250,000 loan amount.
    Example 4. Financial interests. X corporation owns all of the 
outstanding stock of Z corporation. On December 1, 2005, Y corporation 
pays X $1,000,000 in exchange for X's grant of a 9-month call option to 
Y permitting Y to purchase all of the outstanding stock of Z. Y's 
payment to X constitutes an amount paid to create or originate an option 
with X under paragraph (d)(2)(i)(C)(7) of this section. The 9-month term 
of the option does not extend beyond the period prescribed by paragraph 
(f)(1) of this section. However, as provided by paragraph (f)(3) of this 
section, the rules of this paragraph (f) do not apply to intangibles 
described in paragraph (d)(2) of this section. Accordingly, Y must 
capitalize the $1,000,000 payment.
    Example 5. License. (i) On July 1, 2005, R corporation pays $10,000 
to state X to obtain a license to operate a business in state X for a 
period of 5 years. The terms of the license require R to pay state X an 
annual fee of $500 due on July 1, 2005, and each of the succeeding four 
years. R pays the $500 fee on July 1 as required by the license.
    (ii) R's payment of $10,000 is an amount paid to a governmental 
agency for a license granted by that agency to which paragraph (d)(5) of 
this section applies. Because R's payment creates rights or benefits for 
R that extend beyond 12 months after the first date on which R realizes 
the rights or benefits attributable to the payment and beyond the end of 
2006 (the taxable year following the taxable year in which the payment 
is made), the rules of this paragraph (f) do not apply to R's payment. 
Accordingly, R must capitalize the $10,000 payment.
    (iii) R's payment of each $500 annual fee is a prepaid expense 
described in paragraph (d)(3) of this section. R is not required to 
capitalize the $500 fee in each taxable year.

[[Page 440]]

The rules of this paragraph (f) apply to each such payment because each 
payment provides a right or benefit to R that does not extend beyond 12 
months after the first date on which R realizes the rights or benefits 
attributable to the payment and does not extend beyond the end of the 
taxable year following the taxable year in which the payment is made.
    Example 6. Lease. On December 1, 2005, W corporation enters into a 
lease agreement with X corporation under which W agrees to lease 
property to X for a period of 9 months, beginning on December 1, 2005. W 
pays its outside counsel $7,000 for legal services rendered in drafting 
the lease agreement and negotiating with X. The agreement between W and 
X is an agreement providing W the right to be compensated for the use of 
property, as described in paragraph (d)(6)(i)(A) of this section. W's 
$7,000 payment to its outside counsel is an amount paid to facilitate 
W's creation of the lease as described in paragraph (e)(1)(i) of this 
section. The 12-month rule of this paragraph (f) applies to the $7,000 
payment because the right or benefit that the $7,000 payment facilitates 
the creation of neither extends more than 12 months beyond December 1, 
2005 (the first date the benefit is realized by the taxpayer) nor beyond 
the end of the taxable year following the taxable year in which the 
payment is made. Accordingly, W is not required to capitalize its 
payment to its outside counsel.
    Example 7. Certain contract terminations. V corporation owns real 
property that it has leased to A for a period of 15 years. When the 
lease has a remaining unexpired term of 5 years, V and A agree to 
terminate the lease, enabling V to use the property in its trade or 
business. V pays A $100,000 in exchange for A's agreement to terminate 
the lease. V's payment to A to terminate the lease is described in 
paragraph (d)(7)(i)(A) of this section. Under paragraph (f)(2) of this 
section, V's payment creates a benefit for V with a duration of 5 years, 
the remaining unexpired term of the lease as of the date of the 
termination. Because the benefit attributable to the expenditure extends 
beyond 12 months after the first date on which V realizes the rights or 
benefits attributable to the payment and beyond the end of the taxable 
year following the taxable year in which the payment is made, the rules 
of this paragraph (f) do not apply to the payment. V must capitalize the 
$100,000 payment.
    Example 8. Certain contract terminations. Assume the same facts as 
in Example 7, except that the lease is terminated when it has a 
remaining unexpired term of 10 months. Under paragraph (f)(2) of this 
section, V's payment creates a benefit for V with a duration of 10 
months. The 12-month rule of this paragraph (f) applies to the payment 
because the benefit attributable to the payment neither extends more 
than 12 months beyond the date of termination (the first date the 
benefit is realized by V) nor beyond the end of the taxable year 
following the taxable year in which the payment is made. Accordingly, V 
is not required to capitalize the $100,000 payment.
    Example 9. Certain contract terminations. Assume the same facts as 
in Example 7, except that either party can terminate the lease upon 12 
months notice. When the lease has a remaining unexpired term of 5 years, 
V wants to terminate the lease, however, V does not want to wait another 
12 months. V pays A $50,000 for the ability to terminate the lease with 
one month's notice. V's payment to A to terminate the lease is described 
in paragraph (d)(7)(i)(A) of this section. Under paragraph (f)(2) of 
this section, V's payment creates a benefit for V with a duration of 11 
months, the time by which the notice period is shortened. The 12-month 
rule of this paragraph (f) applies to V's $50,000 payment because the 
benefit attributable to the payment neither extends more than 12 months 
beyond the date of termination (the first date the benefit is realized 
by V) nor beyond the end of the taxable year following the taxable year 
in which the payment is made. Accordingly, V is not required to 
capitalize the $50,000 payment.
    Example 10. Coordination with section 461. (i) U corporation leases 
office space from W corporation at a monthly rental rate of $2,000. On 
August 1, 2005, U prepays its office rent expense for the first six 
months of 2006 in the amount of $12,000. For purposes of this example, 
it is assumed that the recurring item exception provided by Sec. 1.461-
5 does not apply and that the lease between W and U is not a section 467 
rental agreement as defined in section 467(d).
    (ii) Under Sec. 1.461-4(d)(3), U's prepayment of rent is a payment 
for the use of property by U for which economic performance occurs 
ratably over the period of time U is entitled to use the property. 
Accordingly, because economic performance with respect to U's prepayment 
of rent does not occur until 2006, U's prepaid rent is not incurred in 
2005 and therefore is not properly taken into account through 
capitalization, deduction, or otherwise in 2005. Thus, the rules of this 
paragraph (f) do not apply to U's prepayment of its rent.
    (iii) Alternatively, assume that U uses the cash method of 
accounting and the economic performance rules in Sec. 1.461-4 therefore 
do not apply to U. The 12-month rule of this paragraph (f) applies to 
the $12,000 payment because the rights or benefits attributable to U's 
prepayment of its rent do not extend beyond December 31, 2006. 
Accordingly, U is not required to capitalize its prepaid rent.
    Example 11. Coordination with section 461. N corporation pays R 
corporation, an advertising and marketing firm, $40,000 on August 1, 
2005, for advertising and marketing services to be provided to N 
throughout calendar

[[Page 441]]

year 2006. For purposes of this example, it is assumed that the 
recurring item exception provided by Sec. 1.461-5 does not apply. Under 
Sec. 1.461-4(d)(2), N's payment arises out of the provision of services 
to N by R for which economic performance occurs as the services are 
provided. Accordingly, because economic performance with respect to N's 
prepaid advertising expense does not occur until 2006, N's prepaid 
advertising expense is not incurred in 2005 and therefore is not 
properly taken into account through capitalization, deduction, or 
otherwise in 2005. Thus, the rules of this paragraph (f) do not apply to 
N's payment.

    (g) Treatment of capitalized costs--(1) In general. An amount 
required to be capitalized by this section is not currently deductible 
under section 162. Instead, the amount generally is added to the basis 
of the intangible acquired or created. See section 1012.
    (2) Financial instruments. In the case of a financial instrument 
described in paragraph (c)(1)(iii) or (d)(2)(i)(C) of this section, 
notwithstanding paragraph (g)(1) of this section, if under other 
provisions of law the amount required to be capitalized is not required 
to be added to the basis of the intangible acquired or created, then the 
other provisions of law will govern the tax treatment of the amount.
    (h) Special rules applicable to pooling--(1) In general. Except as 
otherwise provided, the rules of this paragraph (h) apply to the pooling 
methods described in paragraph (d)(6)(v) of this section (relating to de 
minimis rules applicable to certain contract rights), paragraph 
(e)(4)(iii)(A) of this section (relating to de minimis rules applicable 
to transaction costs), and paragraph (f)(5)(iii) of this section 
(relating to the application of the 12-month rule to renewable rights).
    (2) Method of accounting. A pooling method authorized by this 
section constitutes a method of accounting for purposes of section 446. 
A taxpayer that adopts or changes to a pooling method authorized by this 
section must use the method for the year of adoption and for all 
subsequent taxable years during which the taxpayer qualifies to use the 
pooling method unless a change to another method is required by the 
Commissioner in order to clearly reflect income, or unless permission to 
change to another method is granted by the Commissioner as provided in 
Sec. 1.446-1(e).
    (3) Adopting or changing to a pooling method. A taxpayer adopts (or 
changes to) a pooling method authorized by this section for any taxable 
year by establishing one or more pools for the taxable year in 
accordance with the rules governing the particular pooling method and 
the rules prescribed by this paragraph (h), and by using the pooling 
method to compute its taxable income for the year of adoption (or 
change).
    (4) Definition of pool. A taxpayer may use any reasonable method of 
defining a pool of similar transactions, agreements or rights, including 
a method based on the type of customer or the type of product or service 
provided under a contract. However, a taxpayer that pools similar 
transactions, agreements or rights must include in the pool all similar 
transactions, agreements or rights created during the taxable year. For 
purposes of the pooling methods described in paragraph (d)(6)(v) of this 
section (relating to de minimis rules applicable to certain contract 
rights) and paragraph (e)(4)(iii)(A) of this section (relating to de 
minimis rules applicable to transaction costs), an agreement (or a 
transaction) is treated as not similar to other agreements (or 
transactions) included in the pool if the amount at issue with respect 
to that agreement (or transaction) is reasonably expected to differ 
significantly from the average amount at issue with respect to the other 
agreements (or transactions) properly included in the pool.
    (5) Consistency requirement. A taxpayer that uses the pooling method 
described in paragraph (f)(5)(iii) of this section for purposes of 
applying the 12-month rule to a right or benefit--
    (i) Must use the pooling methods described in paragraph (d)(6)(v) of 
this section (relating to de minimis rules applicable to certain 
contract rights) and paragraph (e)(4)(iii)(A) of this section (relating 
to de minimis rules applicable to transaction costs) for purposes of 
determining the amount paid to create, or facilitate the creation of, 
the right or benefit; and
    (ii) Must use the same pool for purposes of paragraph (d)(6)(v) of 
this section and paragraph (e)(4)(iii)(A) of this

[[Page 442]]

section as is used for purposes of paragraph (f)(5)(iii) of this 
section.
    (6) Additional guidance pertaining to pooling. The Internal Revenue 
Service may publish guidance in the Internal Revenue Bulletin (see Sec. 
601.601(d)(2) of this chapter) prescribing additional rules for applying 
the pooling methods authorized by this section to specific industries or 
to specific types of transactions.
    (7) Example. The following example illustrates the rules of this 
paragraph (h):

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

    (i) [Reserved]
    (j) Application to accrual method taxpayers. For purposes of this 
section, the terms amount paid and payment mean, in the case of a 
taxpayer using an accrual method of accounting, a liability incurred 
(within the meaning of Sec. 1.446-1(c)(1)(ii)). A liability may not be 
taken into account under this section prior to the taxable year during 
which the liability is incurred.
    (k) Treatment of related parties and indirect payments. For purposes 
of this section, references to a party other than the taxpayer include 
persons related to that party and persons acting for or on behalf of 
that party (including persons to whom the taxpayer becomes obligated as 
a result of assuming a liability of that party). For this purpose, 
persons are related only if their relationship is described in section 
267(b) or 707(b) or they are engaged in trades or businesses under 
common control within the meaning of section 41(f)(1). References to an 
amount paid to or by a party include an amount paid on behalf of that 
party.
    (l) Examples. The rules of this section are illustrated by the 
following examples in which it is assumed that the Internal Revenue 
Service has not published guidance that requires capitalization under 
paragraph (b)(1)(iv) of this section (relating to amounts paid to create 
or enhance a future benefit that is identified in published guidance as 
an intangible for which capitalization is required):

    Example 1. License granted by a governmental unit. (i) X corporation 
pays $25,000 to state R to obtain a license to sell alcoholic beverages 
in its restaurant. The license is valid

[[Page 443]]

indefinitely, provided X complies with all applicable laws regarding the 
sale of alcoholic beverages in state R. X pays its outside counsel 
$4,000 for legal services rendered in preparing the license application 
and otherwise representing X during the licensing process. In addition, 
X determines that $2,000 of salaries paid to its employees is allocable 
to services rendered by the employees in obtaining the license.
    (ii) X's payment of $25,000 is an amount paid to a governmental unit 
to obtain a license granted by that agency, as described in paragraph 
(d)(5)(i) of this section. The right has an indefinite duration and 
constitutes an amortizable section 197 intangible. Accordingly, as 
provided in paragraph (f)(3) of this section, the provisions of 
paragraph (f) of this section (relating to the 12-month rule) do not 
apply to X's payment. X must capitalize its $25,000 payment to obtain 
the license from state R.
    (iii) As provided in paragraph (e)(4) of this section, X is not 
required to capitalize employee compensation because such amounts are 
treated as amounts that do not facilitate the acquisition or creation of 
an intangible. Thus, X is not required to capitalize the $2,000 of 
employee compensation allocable to the transaction.
    (iv) X's payment of $4,000 to its outside counsel is an amount paid 
to facilitate the creation of an intangible, as described in paragraph 
(e)(1)(i) of this section. Because X's transaction costs do not exceed 
$5,000, X's transaction costs are de minimis within the meaning of 
paragraph (e)(4)(iii)(A) of this section. Accordingly, X is not required 
to capitalize the $4,000 payment to its outside counsel under this 
section.
    Example 2. Franchise agreement. (i) R corporation is a franchisor of 
income tax return preparation outlets. V corporation negotiates with R 
to obtain the right to operate an income tax return preparation outlet 
under a franchise from R. V pays an initial $100,000 franchise fee to R 
in exchange for the franchise agreement. In addition, V pays its outside 
counsel $4,000 to represent V during the negotiations with R. V also 
pays $2,000 to an industry consultant to advise V during the 
negotiations with R.
    (ii) Under paragraph (d)(6)(i)(A) of this section, V's payment of 
$100,000 is an amount paid to another party to enter into an agreement 
with that party providing V the right to use tangible or intangible 
property. Accordingly, V must capitalize its $100,000 payment to R. The 
franchise agreement is a self-created amortizable section 197 intangible 
within the meaning of section 197(c). Accordingly, as provided in 
paragraph (f)(3) of this section, the 12-month rule contained in 
paragraph (f)(1) of this section does not apply.
    (iii) V's payment of $4,000 to its outside counsel and $2,000 to the 
industry consultant are amounts paid to facilitate the creation of an 
intangible, as described in paragraph (e)(1)(i) of this section. Because 
V's aggregate transaction costs exceed $5,000, V's transaction costs are 
not de minimis within the meaning of paragraph (e)(4)(iii)(A) of this 
section. Accordingly, V must capitalize the $4,000 payment to its 
outside counsel and the $2,000 payment to the industry consultant under 
this section into the basis of the franchise, as provided in paragraph 
(g) of this section.
    Example 3. Covenant not to compete. (i) On December 1, 2005, N 
corporation, a calendar year taxpayer, enters into a covenant not to 
compete with B, a key employee that is leaving the employ of N. The 
covenant not to compete is not entered into in connection with the 
acquisition of an interest in a trade or business. The covenant not to 
compete prohibits B from competing with N for a period of 9 months, 
beginning December 1, 2005. N pays B $25,000 in full consideration for 
B's agreement not to compete. In addition, N pays its outside counsel 
$6,000 to facilitate the creation of the covenant not to compete with B. 
N does not have a short taxable year in 2005 or 2006.
    (ii) Under paragraph (d)(6)(i)(C) of this section, N's payment of 
$25,000 is an amount paid to another party to induce that party to enter 
into a covenant not to compete with N. However, because the covenant not 
to compete has a duration that does not extend beyond 12 months after 
the first date on which N realizes the rights attributable to its 
payment (i.e., December 1, 2005) or beyond the end of the taxable year 
following the taxable year in which payment is made, the 12-month rule 
contained in paragraph (f)(1) of this section applies. Accordingly, N is 
not required to capitalize its $25,000 payment to B or its $6,000 
payment to facilitate the creation of the covenant not to compete.
    Example 4. Demand-side management. (i) X corporation, a public 
utility engaged in generating and distributing electrical energy, 
provides programs to its customers to promote energy conservation and 
energy efficiency. These programs are aimed at reducing electrical costs 
to X's customers, building goodwill with X's customers, and reducing X's 
future operating and capital costs. X provides these programs without 
obligating any of its customers participating in the programs to 
purchase power from X in the future. Under these programs, X pays a 
consultant to help industrial customers design energy-efficient 
manufacturing processes, to conduct ``energy efficiency audits'' that 
serve to identify for customers inefficiencies in their energy usage 
patterns, and to provide cash allowances to encourage residential 
customers to replace existing appliances with more energy efficient 
appliances.
    (ii) The amounts paid by X to the consultant are not amounts to 
acquire or create an intangible under paragraph (c) or (d) of this

[[Page 444]]

section or to facilitate such an acquisition or creation. In addition, 
the amounts do not create a separate and distinct intangible asset 
within the meaning of paragraph (b)(3) of this section. Accordingly, the 
amounts paid to the consultant are not required to be capitalized under 
this section. While the amounts may serve to reduce future operating and 
capital costs and create goodwill with customers, these benefits, 
without more, are not intangibles for which capitalization is required 
under this section.
    Example 5. Business process re-engineering. (i) V corporation 
manufactures its products using a batch production system. Under this 
system, V continuously produces component parts of its various products 
and stockpiles these parts until they are needed in V's final assembly 
line. Finished goods are stockpiled awaiting orders from customers. V 
discovers that this process ties up significant amounts of V's capital 
in work-in-process and finished goods inventories. V hires B, a 
consultant, to advise V on improving the efficiency of its manufacturing 
operations. B recommends a complete re-engineering of V's manufacturing 
process to a process known as just-in-time manufacturing. Just-in-time 
manufacturing involves reconfiguring a manufacturing plant to a 
configuration of ``cells'' where each team in a cell performs the entire 
manufacturing process for a particular customer order, thus reducing 
inventory stockpiles.
    (ii) V incurred three categories of costs to convert its 
manufacturing process to a just-in-time system. First, V paid B, a 
consultant, $250,000 in professional fees to implement the conversion of 
V's plant to a just-in-time system. Second, V paid C, a contractor, 
$100,000 to relocate and reconfigure V's manufacturing equipment from an 
assembly line layout to a configuration of cells. Third, V paid D, a 
consultant, $50,000 to train V's employees in the just-in-time 
manufacturing process.
    (iii) The amounts paid by V to B, C, and D are not amounts to 
acquire or create an intangible under paragraph (c) or (d) of this 
section or to facilitate such an acquisition or creation. In addition, 
the amounts do not create a separate and distinct intangible asset 
within the meaning of paragraph (b)(3) of this section. Accordingly, the 
amounts paid to B, C, and D are not required to be capitalized under 
this section. While the amounts produce long term benefits to V in the 
form of reduced inventory stockpiles, improved product quality, and 
increased efficiency, these benefits, without more, are not intangibles 
for which capitalization is required under this section.
    Example 6. Defense of business reputation. (i) X, an investment 
adviser, serves as the fund manager of a money market investment fund. 
X, like its competitors in the industry, strives to maintain a constant 
net asset value for its money market fund of $1.00 per share. During 
2005, in the course of managing the fund assets, X incorrectly predicts 
the direction of market interest rates, resulting in significant 
investment losses to the fund. Due to these significant losses, X is 
faced with the prospect of reporting a net asset value that is less than 
$1.00 per share. X is not aware of any investment adviser in its 
industry that has ever reported a net asset value for its money market 
fund of less than $1.00 per share. X is concerned that reporting a net 
asset value of less than $1.00 per share will significantly harm its 
reputation as an investment adviser, and could lead to litigation by 
shareholders. X decides to contribute $2,000,000 to the fund in order to 
raise the net asset value of the fund to $1.00 per share. This 
contribution is not a loan to the fund and does not give X any ownership 
interest in the fund.
    (ii) The $2,000,000 contribution is not an amount paid to acquire or 
create an intangible under paragraph (c) or (d) of this section or to 
facilitate such an acquisition or creation. In addition, the amount does 
not create a separate and distinct intangible asset within the meaning 
of paragraph (b)(3) of this section. Accordingly, the amount contributed 
to the fund is not required to be capitalized under this section. While 
the amount serves to protect the business reputation of the taxpayer and 
may protect the taxpayer from litigation by shareholders, these 
benefits, without more, are not intangibles for which capitalization is 
required under this section.
    Example 7. Product launch costs. (i) R corporation, a manufacturer 
of pharmaceutical products, is required by law to obtain regulatory 
approval before selling its products. While awaiting regulatory approval 
on Product A, R pays to develop and implement a marketing strategy and 
an advertising campaign to raise consumer awareness of the purported 
need for Product A. R also pays to train health care professionals and 
other distributors in the proper use of Product A.
    (ii) The amounts paid by R are not amounts paid to acquire or create 
an intangible under paragraph (c) or (d) of this section or to 
facilitate such an acquisition or creation. In addition, the amounts do 
not create a separate and distinct intangible asset within the meaning 
of paragraph (b)(3) of this section. Accordingly, R is not required to 
capitalize these amounts under this section. While the amounts may 
benefit R by creating consumer demand for Product A and increasing 
awareness of Product A among distributors, these benefits, without more, 
are not intangibles for which capitalization is required under this 
section.
    Example 8. Stocklifting costs. (i) N corporation is a wholesale 
distributor of Brand A aftermarket automobile replacement parts. In an 
effort to induce a retail automobile

[[Page 445]]

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

[[Page 446]]

best efforts to solicit orders for the sale of shares of M. D sells 
shares in M directly to the general public as well as through brokers. 
When an investor places an order for M shares with a broker, D pays the 
broker a commission for selling the shares to the investor. Under the 
distribution agreement, D receives compensation from M in the form of 
12b-1 fees (which equal a percentage of M's net asset value attributable 
to investors that have held their shares for up to 6 years) and 
contingent deferred sales charges (which are paid if the investor 
redeems the purchased shares within 6 years).
    (ii) The distribution agreement is not an agreement providing D with 
the right to provide services, as described in paragraph (d)(6)(i)(B) of 
this section, because the distribution agreement can be terminated by M 
at will upon 60 days notice and M is not economically compelled to 
continue the distribution agreement. Accordingly, D is not required to 
capitalize the costs of creating (or facilitating the creation of) the 
distribution agreement under paragraphs (b)(1)(ii) or (v) of this 
section. In addition, as provided in paragraph (b)(3)(ii) of this 
section, amounts paid to create an agreement are treated as amounts that 
do not create a separate and distinct intangible asset. Accordingly, D 
also is not required to capitalize the costs of creating (or 
facilitating the creation of) the distribution agreement under paragraph 
(b)(1)(iii) or (v) of this section.
    (iii) Under paragraph (b)(3)(iii), the broker commissions paid by D 
in performing services under the distribution agreement do not create 
(or facilitate the creation of) a separate and distinct intangible 
asset. In addition, the broker commissions do not create an intangible 
described in paragraph (d) of this section. Accordingly, D is not 
required to capitalize the broker commissions under this section.

    (m) Amortization. For rules relating to amortization of certain 
intangibles, see Sec. 1.167(a)-3.
    (n) Intangible interests in land. [Reserved].
    (o) Effective date. This section applies to amounts paid or incurred 
on or after December 31, 2003.
    (p) Accounting method changes--(1) In general. A taxpayer seeking to 
change a method of accounting to comply with this section must secure 
the consent of the Commissioner in accordance with the requirements of 
Sec. 1.446-1(e). For the taxpayer's first taxable year ending on or 
after December 31, 2003, the taxpayer is granted the consent of the 
Commissioner to change its method of accounting to comply with this 
section, provided the taxpayer follows the administrative procedures 
issued under Sec. 1.446-1(e)(3)(ii) for obtaining the Commissioner's 
automatic consent to a change in accounting method (for further 
guidance, for example, see Rev. Proc. 2002-9 (2002-1 C.B. 327) and Sec. 
601.601(d)(2)(ii)(b) of this chapter).
    (2) Scope limitations. Any limitations on obtaining the automatic 
consent of the Commissioner do not apply to a taxpayer seeking to change 
to a method of accounting to comply with this section for its first 
taxable year ending on or after December 31, 2003.
    (3) Section 481(a) adjustment. With the exception of a change to a 
pooling method authorized by this section, the section 481(a) adjustment 
for a change in method of accounting to comply with this section for a 
taxpayer's first taxable year ending on or after December 31, 2003 is 
determined by taking into account only amounts paid or incurred in 
taxable years ending on or after January 24, 2002. A taxpayer seeking to 
change to a pooling method authorized by this section on or after the 
effective date of these regulations must change to the method using a 
cut-off method.

[T.D. 9107, 69 FR 446, Jan. 5, 2004]