[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)-5]

[Page 446-455]
 
                       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)-5  Amounts paid or incurred to facilitate an acquisition 

of a trade or business, a change in the capital structure of a business 
entity, and certain other transactions.

    (a) General rule. A taxpayer must capitalize an amount paid to 
facilitate (within the meaning of paragraph (b) of this section) each of 
the following transactions, without regard to whether the transaction is 
comprised of a single step or a series of steps carried out as part of a 
single plan and without regard to whether gain or loss is recognized in 
the transaction:
    (1) An acquisition of assets that constitute a trade or business 
(whether the taxpayer is the acquirer in the acquisition or the target 
of the acquisition).
    (2) An acquisition by the taxpayer of an ownership interest in a 
business entity if, immediately after the acquisition, the taxpayer and 
the business entity are related within the meaning of section 267(b) or 
707(b) (see Sec. 1.263(a)-4 for rules requiring capitalization of

[[Page 447]]

amounts paid by the taxpayer to acquire an ownership interest in a 
business entity, or to facilitate the acquisition of an ownership 
interest in a business entity, where the taxpayer and the business 
entity are not related within the meaning of section 267(b) or 707(b) 
immediately after the acquisition).
    (3) An acquisition of an ownership interest in the taxpayer (other 
than an acquisition by the taxpayer of an ownership interest in the 
taxpayer, whether by redemption or otherwise).
    (4) A restructuring, recapitalization, or reorganization of the 
capital structure of a business entity (including reorganizations 
described in section 368 and distributions of stock by the taxpayer as 
described in section 355).
    (5) A transfer described in section 351 or section 721 (whether the 
taxpayer is the transferor or transferee).
    (6) A formation or organization of a disregarded entity.
    (7) An acquisition of capital.
    (8) A stock issuance.
    (9) A borrowing. For purposes of this section, a borrowing means any 
issuance of debt, including an issuance of debt in an acquisition of 
capital or in a recapitalization. A borrowing also includes debt issued 
in a debt for debt exchange under Sec. 1.1001-3.
    (10) Writing an option.
    (b) Scope of facilitate--(1) In general. Except as otherwise 
provided in this section, an amount is paid to facilitate a transaction 
described in paragraph (a) of this section if the amount is paid in the 
process of investigating or otherwise pursuing the transaction. Whether 
an amount is paid in the process of investigating or otherwise pursuing 
the transaction is determined based on all of the facts and 
circumstances. In determining whether an amount is paid to facilitate a 
transaction, the fact that the amount would (or would not) have been 
paid but for the transaction is relevant, but is not determinative. An 
amount paid to determine the value or price of a transaction is an 
amount paid in the process of investigating or otherwise pursuing the 
transaction. An amount paid to another party in exchange for tangible or 
intangible property is not an amount paid to facilitate the exchange. 
For example, the purchase price paid to the target of an asset 
acquisition in exchange for its assets is not an amount paid to 
facilitate the acquisition. Similarly, the purchase price paid by an 
acquirer to the target's shareholders in exchange for their stock in a 
stock acquisition is not an amount paid to facilitate the acquisition of 
the stock. See Sec. 1.263(a)-1, Sec. 1.263(a)-2, and Sec. 1.263(a)-4 
for rules requiring capitalization of the purchase price paid to acquire 
property.
    (2) Ordering rules. An amount paid in the process of investigating 
or otherwise pursuing both a transaction described in paragraph (a) of 
this section and an acquisition or creation of an intangible described 
in Sec. 1.263(a)-4 is subject to the rules contained in this section, 
and not to the rules contained in Sec. 1.263(a)-4. In addition, an 
amount required to be capitalized by Sec. 1.263(a)-1, Sec. 1.263(a)-2, 
or Sec. 1.263(a)-4 does not facilitate a transaction described in 
paragraph (a) of this section.
    (c) Special rules for certain costs--(1) Borrowing costs. An amount 
paid to facilitate a borrowing does not facilitate another transaction 
(other than the borrowing) described in paragraph (a) of this section.
    (2) Costs of asset sales. An amount paid by a taxpayer to facilitate 
a sale of its assets does not facilitate another transaction (other than 
the sale) described in paragraph (a) of this section. For example, where 
a target corporation, in preparation for a merger with an acquiring 
corporation, sells assets that are not desired by the acquiring 
corporation, amounts paid to facilitate the sale of the unwanted assets 
are not required to be capitalized as amounts paid to facilitate the 
merger.
    (3) Mandatory stock distributions. An amount paid in the process of 
investigating or otherwise pursuing a distribution of stock by a 
taxpayer to its shareholders does not facilitate a transaction described 
in paragraph (a) of this section if the divestiture of the stock (or of 
properties transferred to an entity whose stock is distributed) is 
required by law, regulatory mandate, or court order. A taxpayer is not 
required to capitalize (under this section or Sec. 1.263(a)-4) an 
amount paid to organize (or facilitate the organization of)

[[Page 448]]

an entity if the entity is organized solely to receive properties that 
the taxpayer is required to divest by law, regulatory mandate, or court 
order and if the taxpayer distributes the stock of the entity to its 
shareholders. A taxpayer also is not required to capitalize (under this 
section or Sec. 1.263(a)-4) an amount paid to transfer property to an 
entity if the taxpayer is required to divest itself of that property by 
law, regulatory mandate, or court order and if the stock of the 
recipient entity is distributed to the taxpayer's shareholders.
    (4) Bankruptcy reorganization costs. An amount paid to institute or 
administer a proceeding under Chapter 11 of the Bankruptcy Code by a 
taxpayer that is the debtor under the proceeding constitutes an amount 
paid to facilitate a reorganization within the meaning of paragraph 
(a)(4) of this section, regardless of the purpose for which the 
proceeding is instituted. For example, an amount paid to prepare and 
file a petition under Chapter 11, to obtain an extension of the 
exclusivity period under Chapter 11, to formulate plans of 
reorganization under Chapter 11, to analyze plans of reorganization 
formulated by another party in interest, or to contest or obtain 
approval of a plan of reorganization under Chapter 11 facilitates a 
reorganization within the meaning of this section. However, amounts 
specifically paid to formulate, analyze, contest or obtain approval of 
the portion of a plan of reorganization under Chapter 11 that resolves 
tort liabilities of the taxpayer do not facilitate a reorganization 
within the meaning of paragraph (a)(4) of this section if the amounts 
would have been treated as ordinary and necessary business expenses 
under section 162 had the bankruptcy proceeding not been instituted. In 
addition, an amount paid by the taxpayer to defend against the 
commencement of an involuntary bankruptcy proceeding against the 
taxpayer does not facilitate a reorganization within the meaning of 
paragraph (a)(4) of this section. An amount paid by the debtor to 
operate its business during a Chapter 11 bankruptcy proceeding is not an 
amount paid to institute or administer the bankruptcy proceeding and 
does not facilitate a reorganization. Such amount is treated in the same 
manner as it would have been treated had the bankruptcy proceeding not 
been instituted.
    (5) Stock issuance costs of open-end regulated investment companies. 
Amounts paid by an open-end regulated investment company (within the 
meaning of section 851) to facilitate an issuance of its stock are 
treated as amounts that do not facilitate a transaction described in 
paragraph (a) of this section unless the amounts are paid during the 
initial stock offering period.
    (6) Integration costs. An amount paid to integrate the business 
operations of the taxpayer with the business operations of another does 
not facilitate a transaction described in paragraph (a) of this section, 
regardless of when the integration activities occur.
    (7) Registrar and transfer agent fees for the maintenance of capital 
stock records. An amount paid by a taxpayer to a registrar or transfer 
agent in connection with the transfer of the taxpayer's capital stock 
does not facilitate a transaction described in paragraph (a) of this 
section unless the amount is paid with respect to a specific transaction 
described in paragraph (a). For example, a taxpayer is not required to 
capitalize periodic payments to a transfer agent for maintaining records 
of the names and addresses of shareholders who trade the taxpayer's 
shares on a national exchange. By comparison, a taxpayer is required to 
capitalize an amount paid to the transfer agent for distributing proxy 
statements requesting shareholder approval of a transaction described in 
paragraph (a) of this section.
    (8) Termination payments and amounts paid to facilitate mutually 
exclusive transactions. An amount paid to terminate (or facilitate the 
termination of) an agreement to enter into a transaction described in 
paragraph (a) of this section constitutes an amount paid to facilitate a 
second transaction described in paragraph (a) of this section only if 
the transactions are mutually exclusive. An amount paid to facilitate a 
transaction described in paragraph (a) of this section is treated as an 
amount paid to facilitate a second transaction described in paragraph

[[Page 449]]

(a) of this section only if the transactions are mutually exclusive.
    (d) Simplifying conventions--(1) In general. For purposes of this 
section, employee compensation (within the meaning of paragraph (d)(2) 
of this section), overhead, and de minimis costs (within the meaning of 
paragraph (d)(3) of this section) are treated as amounts that do not 
facilitate a transaction described in paragraph (a) of this section.
    (2) Employee compensation--(i) In general. The term employee 
compensation means compensation (including salary, bonuses and 
commissions) paid to an employee of the taxpayer. For purposes of this 
section, whether an individual is an employee is determined in 
accordance with the rules contained in section 3401(c) and the 
regulations thereunder.
    (ii) Certain amounts treated as employee compensation. For purposes 
of this section, a guaranteed payment to a partner in a partnership is 
treated as employee compensation. For purposes of this section, annual 
compensation paid to a director of a corporation is treated as employee 
compensation. For example, an amount paid to a director of a corporation 
for attendance at a regular meeting of the board of directors (or 
committee thereof) is treated as employee compensation for purposes of 
this section. However, an amount paid to the director for attendance at 
a special meeting of the board of directors (or committee thereof) is 
not treated as employee compensation. An amount paid to a person that is 
not an employee of the taxpayer (including the employer of the 
individual who performs the services) is treated as employee 
compensation for purposes of this section only if the amount is paid for 
secretarial, clerical, or similar administrative support services (other 
than services involving the preparation and distribution of proxy 
solicitations and other documents seeking shareholder approval of a 
transaction described in paragraph (a) of this section). In the case of 
an affiliated group of corporations filing a consolidated federal income 
tax return, a payment by one member of the group to a second member of 
the group for services performed by an employee of the second member is 
treated as employee compensation if the services provided by the 
employee are provided at a time during which both members are 
affiliated.
    (3) De minimis costs--(i) In general. The term de minimis costs 
means amounts (other than employee compensation and overhead) paid in 
the process of investigating or otherwise pursuing a transaction 
described in paragraph (a) of this section if, in the aggregate, the 
amounts do not exceed $5,000 (or such greater amount as may be set forth 
in published guidance). If the amounts exceed $5,000 (or such greater 
amount as may be set forth in published guidance), none of the amounts 
are de minimis costs within the meaning of this paragraph (d)(3). For 
purposes of this paragraph (d)(3), an amount paid in the form of 
property is valued at its fair market value at the time of the payment.
    (ii) Treatment of commissions. The term de minimis costs does not 
include commissions paid to facilitate a transaction described in 
paragraph (a) of this section.
    (4) Election to capitalize. A taxpayer may elect to treat employee 
compensation, overhead, or de minimis costs paid in the process of 
investigating or otherwise pursuing a transaction described in paragraph 
(a) of this section as amounts that facilitate the transaction. The 
election is made separately for each transaction and applies to employee 
compensation, overhead, or de minimis costs, or to any combination 
thereof. For example, a taxpayer may elect to treat overhead and de 
minimis costs, but not employee compensation, as amounts that facilitate 
the transaction. A taxpayer makes the election by treating the amounts 
to which the election applies as amounts that facilitate the transaction 
in the taxpayer's timely filed original federal income tax return 
(including extensions) for the taxable year during which the amounts are 
paid. In the case of an affiliated group of corporations filing a 
consolidated return, the election is made separately with respect to 
each member of the group, and not with respect to the group as a whole. 
In the case of an S corporation or partnership, the election is made by 
the S corporation or by

[[Page 450]]

the partnership, and not by the shareholders or partners. An election 
made under this paragraph (d)(4) is revocable with respect to each 
taxable year for which made only with the consent of the Commissioner.
    (e) Certain acquisitive transactions--(1) In general. Except as 
provided in paragraph (e)(2) of this section (relating to inherently 
facilitative amounts), an amount paid by the taxpayer in the process of 
investigating or otherwise pursuing a covered transaction (as described 
in paragraph (e)(3) of this section) facilitates the transaction within 
the meaning of this section only if the amount relates to activities 
performed on or after the earlier of--
    (i) The date on which a letter of intent, exclusivity agreement, or 
similar written communication (other than a confidentiality agreement) 
is executed by representatives of the acquirer and the target; or
    (ii) The date on which the material terms of the transaction (as 
tentatively agreed to by representatives of the acquirer and the target) 
are authorized or approved by the taxpayer's board of directors (or 
committee of the board of directors) or, in the case of a taxpayer that 
is not a corporation, the date on which the material terms of the 
transaction (as tentatively agreed to by representatives of the acquirer 
and the target) are authorized or approved by the appropriate governing 
officials of the taxpayer. In the case of a transaction that does not 
require authorization or approval of the taxpayer's board of directors 
(or appropriate governing officials in the case of a taxpayer that is 
not a corporation) the date determined under this paragraph (e)(1)(ii) 
is the date on which the acquirer and the target execute a binding 
written contract reflecting the terms of the transaction.
    (2) Exception for inherently facilitative amounts. An amount paid in 
the process of investigating or otherwise pursuing a covered transaction 
facilitates that transaction if the amount is inherently facilitative, 
regardless of whether the amount is paid for activities performed prior 
to the date determined under paragraph (e)(1) of this section. An amount 
is inherently facilitative if the amount is paid for--
    (i) Securing an appraisal, formal written evaluation, or fairness 
opinion related to the transaction;
    (ii) Structuring the transaction, including negotiating the 
structure of the transaction and obtaining tax advice on the structure 
of the transaction (for example, obtaining tax advice on the application 
of section 368);
    (iii) Preparing and reviewing the documents that effectuate the 
transaction (for example, a merger agreement or purchase agreement);
    (iv) Obtaining regulatory approval of the transaction, including 
preparing and reviewing regulatory filings;
    (v) Obtaining shareholder approval of the transaction (for example, 
proxy costs, solicitation costs, and costs to promote the transaction to 
shareholders); or
    (vi) Conveying property between the parties to the transaction (for 
example, transfer taxes and title registration costs).
    (3) Covered transactions. For purposes of this paragraph (e), the 
term covered transaction means the following transactions:
    (i) A taxable acquisition by the taxpayer of assets that constitute 
a trade or business.
    (ii) A taxable acquisition of an ownership interest in a business 
entity (whether the taxpayer is the acquirer in the acquisition or the 
target of the acquisition) if, immediately after the acquisition, the 
acquirer and the target are related within the meaning of section 267(b) 
or 707(b).
    (iii) A reorganization described in section 368(a)(1)(A), (B), or 
(C) or a reorganization described in section 368(a)(1)(D) in which stock 
or securities of the corporation to which the assets are transferred are 
distributed in a transaction which qualifies under section 354 or 356 
(whether the taxpayer is the acquirer or the target in the 
reorganization).
    (f) Documentation of success-based fees--An amount paid that is 
contingent on the successful closing of a transaction described in 
paragraph (a) of this section is an amount paid to facilitate the 
transaction except to the extent the taxpayer maintains sufficient 
documentation to establish that

[[Page 451]]

a portion of the fee is allocable to activities that do not facilitate 
the transaction. This documentation must be completed on or before the 
due date of the taxpayer's timely filed original federal income tax 
return (including extensions) for the taxable year during which the 
transaction closes. For purposes of this paragraph (f), documentation 
must consist of more than merely an allocation between activities that 
facilitate the transaction and activities that do not facilitate the 
transaction, and must consist of supporting records (for example, time 
records, itemized invoices, or other records) that identify--
    (1) The various activities performed by the service provider;
    (2) The amount of the fee (or percentage of time) that is allocable 
to each of the various activities performed;
    (3) Where the date the activity was performed is relevant to 
understanding whether the activity facilitated the transaction, the 
amount of the fee (or percentage of time) that is allocable to the 
performance of that activity before and after the relevant date; and
    (4) The name, business address, and business telephone number of the 
service provider.
    (g) Treatment of capitalized costs--(1) Tax-free acquisitive 
transactions. [Reserved]
    (2) Taxable acquisitive transactions--(i) Acquirer. In the case of 
an acquisition, merger, or consolidation that is not described in 
section 368, an amount required to be capitalized under this section by 
the acquirer is added to the basis of the acquired assets (in the case 
of a transaction that is treated as an acquisition of the assets of the 
target for federal income tax purposes) or the acquired stock (in the 
case of a transaction that is treated as an acquisition of the stock of 
the target for federal income tax purposes).
    (ii) Target--(A) Asset acquisition. In the case of an acquisition, 
merger, or consolidation that is not described in section 368 and that 
is treated as an acquisition of the assets of the target for federal 
income tax purposes, an amount required to be capitalized under this 
section by the target is treated as a reduction of the target's amount 
realized on the disposition of its assets.
    (B) Stock acquisition. [Reserved]
    (3) Stock issuance transactions. [Reserved]
    (4) Borrowings. For the treatment of amounts required to be 
capitalized under this section with respect to a borrowing, see Sec. 
1.446-5.
    (5) Treatment of capitalized amounts by option writer. An amount 
required to be capitalized by an option writer under paragraph (a)(10) 
of this section is not currently deductible under section 162 or 212. 
Instead, the amount required to be capitalized generally reduces the 
total premium received by the option writer. However, other provisions 
of law may limit the reduction of the premium by the capitalized amount 
(for example, if the capitalized amount is never deductible by the 
option writer).
    (h) Application to accrual method taxpayers. For purposes of this 
section, the terms amount paid and payment mean, in the case of a 
taxpayer using an accrual method of accounting, a liability incurred 
(within the meaning of Sec. 1.446-1(c)(1)(ii)). A liability may not be 
taken into account under this section prior to the taxable year during 
which the liability is incurred.
    (i) [Reserved]
    (j) Coordination with other provisions of the Internal Revenue Code. 
Nothing in this section changes the treatment of an amount that is 
specifically provided for under any other provision of the Internal 
Revenue Code (other than section 162(a) or 212) or regulations 
thereunder.
    (k) Treatment of indirect payments. For purposes of this section, 
references to an amount paid to or by a party include an amount paid on 
behalf of that party.
    (l) Examples. The following examples illustrate the rules of this 
section:

    Example 1. Costs to facilitate. Q corporation pays its outside 
counsel $20,000 to assist Q in registering its stock with the Securities 
and Exchange Commission. Q is not a regulated investment company within 
the meaning of section 851. Q's payments to its outside counsel are 
amounts paid to facilitate the issuance of stock. Accordingly, Q must 
capitalize its $20,000 payment under paragraph (a)(8) of this section 
(whether incurred before

[[Page 452]]

or after the issuance of the stock and whether or not the registration 
is productive of equity capital).
    Example 2. Costs to facilitate. Q corporation seeks to acquire all 
of the outstanding stock of Y corporation. To finance the acquisition, Q 
must issue new debt. Q pays an investment banker $25,000 to market the 
debt to the public and pays its outside counsel $10,000 to prepare the 
offering documents for the debt. Q's payment of $35,000 facilitates a 
borrowing and must be capitalized under paragraph (a)(9) of this 
section. As provided in paragraph (c)(1) of this section, Q's payment 
does not facilitate the acquisition of Y, notwithstanding the fact that 
Q incurred the new debt to finance its acquisition of Y. See Sec. 
1.446-5 for the treatment of Q's capitalized payment.
    Example 3. Costs to facilitate. (i) Z agrees to pay investment 
banker B $1,000,000 for B's services in evaluating four alternative 
transactions ($250,000 for each alternative): An initial public 
offering; a borrowing of funds; an acquisition by Z of a competitor; and 
an acquisition of Z by a competitor. Z eventually decides to pursue a 
borrowing and abandons the other options.
    (ii) The $250,000 payment to evaluate the possibility of a borrowing 
is an amount paid in the process of investigating or otherwise pursuing 
a transaction described in paragraph (a)(9) of this section. Accordingly 
Z must capitalize that $250,000 payment to B. See Sec. 1.446-5 for the 
treatment of Z's capitalized payment.
    (iii) The $250,000 payment to evaluate the possibility of an initial 
public offering is an amount paid in the process of investigating or 
otherwise pursuing a transaction described in paragraph (a)(8) of this 
section. Accordingly, Z must capitalize that $250,000 payment to B under 
this section. Because the borrowing and the initial public offering are 
not mutually exclusive transactions, the $250,000 is not treated as an 
amount paid to facilitate the borrowing. When Z abandons the initial 
public offering, Z may recover under section 165 the $250,000 paid to 
facilitate the initial public offering.
    (iv) The $500,000 paid by Z to evaluate the possibilities of an 
acquisition of Z by a competitor and an acquisition of a competitor by Z 
are amounts paid in the process of investigating or otherwise pursuing 
transactions described in paragraphs (a) and (e)(3) of this section. 
Accordingly, Z is only required to capitalize under this section the 
portion of the $500,000 payment that relates to inherently facilitative 
activities under paragraph (e)(2) of this section or to activities 
performed on or after the date determined under paragraph (e)(1) of this 
section. Because the borrowing and the possible acquisitions are not 
mutually exclusive transactions, no portion of the $500,000 is treated 
as an amount paid to facilitate the borrowing. When Z abandons the 
acquisition transactions, Z may recover under section 165 any portion of 
the $500,000 that was paid to facilitate the acquisitions.
    Example 4. Corporate acquisition. (i) On February 1, 2005, R 
corporation decides to investigate the acquisition of three potential 
targets: T corporation, U corporation, and V corporation. R's 
consideration of T, U, and V represents the consideration of three 
distinct transactions, any or all of which R might consummate and has 
the financial ability to consummate. On March 1, 2005, R enters into an 
exclusivity agreement with T and stops pursuing U and V. On July 1, 
2005, R acquires all of the stock of T in a transaction described in 
section 368. R pays $1,000,000 to an investment banker and $50,000 to 
its outside counsel to conduct due diligence on T, U, and V; determine 
the value of T, U, and V; negotiate and structure the transaction with 
T; draft the merger agreement; secure shareholder approval; prepare SEC 
filings; and obtain the necessary regulatory approvals.
    (ii) Under paragraph (e)(1) of this section, the amounts paid to 
conduct due diligence on T, U and V prior to March 1, 2005 (the date of 
the exclusivity agreement) are not amounts paid to facilitate the 
acquisition of the stock of T, U or V and are not required to be 
capitalized under this section. However, the amounts paid to conduct due 
diligence on T on and after March 1, 2005, are amounts paid to 
facilitate the acquisition of the stock of T and must be capitalized 
under paragraph (a)(2) of this section.
    (iii) Under paragraph (e)(2) of this section, the amounts paid to 
determine the value of T, negotiate and structure the transaction with 
T, draft the merger agreement, secure shareholder approval, prepare SEC 
filings, and obtain necessary regulatory approvals are inherently 
facilitative amounts paid to facilitate the acquisition of the stock of 
T and must be capitalized, regardless of whether those activities occur 
prior to, on, or after March 1, 2005.
    (iv) Under paragraph (e)(2) of this section, the amounts paid to 
determine the value of U and V are inherently facilitative amounts paid 
to facilitate the acquisition of U or V and must be capitalized. Because 
the acquisition of U, V, and T are not mutually exclusive transactions, 
the costs that facilitate the acquisition of U and V do not facilitate 
the acquisition of T. Accordingly, the amounts paid to determine the 
value of U and V may be recovered under section 165 in the taxable year 
that R abandons the planned mergers with U and V.
    Example 5. Corporate acquisition; employee bonus. Assume the same 
facts as in Example 4, except R pays a bonus of $10,000 to one of its 
corporate officers who negotiated the acquisition of T. As provided by 
paragraph (d)(1) of this section, Y is not required to

[[Page 453]]

capitalize any portion of the bonus paid to the corporate officer.
    Example 6. Corporate acquisition; integration costs. Assume the same 
facts as in Example 4, except that, before and after the acquisition is 
consummated, R incurs costs to relocate personnel and equipment, provide 
severance benefits to terminated employees, integrate records and 
information systems, prepare new financial statements for the combined 
entity, and reduce redundancies in the combined business operations. 
Under paragraph (c)(6) of this section, these costs do not facilitate 
the acquisition of T. Accordingly, R is not required to capitalize any 
of these costs under this section.
    Example 7. Corporate acquisition; compensation to target's 
employees. Assume the same facts as in Example 4, except that, prior to 
the acquisition, certain employees of T held unexercised options issued 
pursuant to T's stock option plan. These options granted the employees 
the right to purchase T stock at a fixed option price. The options did 
not have a readily ascertainable value (within the meaning of Sec. 
1.83-7(b)), and thus no amount was included in the employees' income 
when the options were granted. As a condition of the acquisition, T is 
required to terminate its stock option plan. T therefore agrees to pay 
its employees who hold unexercised stock options the difference between 
the option price and the current value of T's stock in consideration of 
their agreement to cancel their unexercised options. Under paragraph 
(d)(1) of this section, T is not required to capitalize the amounts paid 
to its employees. See section 83 for the treatment of amounts received 
in cancellation of stock options.
    Example 8. Asset acquisition; employee compensation. N corporation 
owns tangible and intangible assets that constitute a trade or business. 
M corporation purchases all the assets of N in a taxable transaction. 
Under paragraph (a)(1) of this section, M must capitalize amounts paid 
to facilitate the acquisition of the assets of N. Under paragraph (d)(1) 
of this section, no portion of the salaries of M's employees who work on 
the acquisition are treated as facilitating the transaction.
    Example 9. Corporate acquisition; retainer. Y corporation's outside 
counsel charges Y $60,000 for services rendered in facilitating the 
friendly acquisition of the stock of Y corporation by X corporation. Y 
has an agreement with its outside counsel under which Y pays an annual 
retainer of $50,000. Y's outside counsel has the right to offset amounts 
billed for any legal services rendered against the annual retainer. 
Pursuant to this agreement, Y's outside counsel offsets $50,000 of the 
legal fees from the acquisition against the retainer and bills Y for the 
balance of $10,000. The $60,000 legal fee is an amount paid to 
facilitate the acquisition of an ownership interest in Y as described in 
paragraph (a)(3) of this section. Y must capitalize the full amount of 
the $60,000 legal fee.
    Example 10. Corporate acquisition; antitrust defense costs. On March 
1, 2005, V corporation enters into an agreement with X corporation to 
acquire all of the outstanding stock of X. On April 1, 2005, federal and 
state regulators file suit against V to prevent the acquisition of X on 
the ground that the acquisition violates antitrust laws. V enters into a 
consent agreement with regulators on May 1, 2005, that allows the 
acquisition to proceed, but requires V to hold separate the business 
operations of X pending the outcome of the antitrust suit and subjects V 
to possible divestiture. V acquires title to all of the outstanding 
stock of X on June 1, 2005. After June 1, 2005, the regulators pursue 
antitrust litigation against V seeking rescission of the acquisition. V 
pays $50,000 to its outside counsel for services rendered after June 1, 
2005, to defend against the antitrust litigation. V ultimately prevails 
in the antitrust litigation. V's costs to defend the antitrust 
litigation are costs to facilitate its acquisition of the stock of X 
under paragraph (a)(2) of this section and must be capitalized. Although 
title to the shares of X passed to V prior to the date V incurred costs 
to defend the antitrust litigation, the amounts paid by V are paid in 
the process of pursuing the acquisition of the stock of X because the 
acquisition was not complete until the antitrust litigation was 
ultimately resolved. V must capitalize the $50,000 in legal fees.
    Example 11. Corporate acquisition; defensive measures. (i) On 
January 15, 2005, Y corporation, a publicly traded corporation, becomes 
the target of a hostile takeover attempt by Z corporation. In an effort 
to defend against the takeover, Y pays legal fees to seek an injunction 
against the takeover and investment banking fees to locate a potential 
``white knight'' acquirer. Y also pays amounts to complete a defensive 
recapitalization, and pays $50,000 to an investment banker for a 
fairness opinion regarding Z's initial offer. Y's efforts to enjoin the 
takeover and locate a white knight acquirer are unsuccessful, and on 
March 15, 2005, Y's board of directors decides to abandon its defense 
against the takeover and negotiate with Z in an effort to obtain the 
highest possible price for its shareholders. After Y abandons its 
defense against the takeover, Y pays an investment banker $1,000,000 for 
a second fairness opinion and for services rendered in negotiating with 
Z.
    (ii) The legal fees paid by Y to seek an injunction against the 
takeover are not amounts paid in the process of investigating or 
otherwise pursuing the transaction with Z. Accordingly, these legal fees 
are not required to be capitalized under this section.

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    (iii) The investment banking fees paid to search for a white knight 
acquirer do not facilitate an acquisition of Y by a white knight because 
none of Y's costs with respect to a white knight were inherently 
facilitative amounts and because Y did not reach the date described in 
paragraph (e)(1) of this section with respect to a white knight. 
Accordingly, these amounts are not required to be capitalized under this 
section.
    (iv) The amounts paid by Y to investigate and complete the 
recapitalization must be capitalized under paragraph (a)(4) of this 
section.
    (v) The $50,000 paid to the investment bankers for a fairness 
opinion during Y's defense against the takeover and the $1,000,000 paid 
to the investment bankers after Y abandons its defense against the 
takeover are inherently facilitative amounts with respect to the 
transaction with Z and must be capitalized under paragraph (a)(3) of 
this section.
    Example 12. Corporate acquisition; acquisition by white knight. (i) 
Assume the same facts as in Example 11, except that Y's investment 
bankers identify three potential white knight acquirers: U corporation, 
V corporation, and W corporation. Y pays its investment bankers to 
conduct due diligence on the three potential white knight acquirers. On 
March 15, 2005, Y's board of directors approves a tentative acquisition 
agreement under which W agrees to acquire all of the stock of Y, and the 
investment bankers stop due diligence on U and V. On June 15, 2005, W 
acquires all of the stock of Y.
    (ii) Under paragraph (e)(1) of this section, the amounts paid to 
conduct due diligence on U, V, and W prior to March 15, 2005 (the date 
of board of directors' approval) are not amounts paid to facilitate the 
acquisition of the stock of Y and are not required to be capitalized 
under this section. However, the amounts paid to conduct due diligence 
on W on and after March 15, 2005, facilitate the acquisition of the 
stock of Y and are required to be capitalized.
    EXAMPLE 13. Corporate acquisition; mutually exclusive costs. (i) 
Assume the same facts as in Example 11, except that Y's investment 
banker finds W, a white knight. Y and W execute a letter of intent on 
March 10, 2005. Under the terms of the letter of intent, Y must pay W a 
$10,000,000 break-up fee if the merger with W does not occur. On April 
1, 2005, Z significantly increases the amount of its offer, and Y 
decides to accept Z's offer instead of merging with W. Y pays its 
investment banker $500,000 for inherently facilitative costs with 
respect to the potential merger with W. Y also pays its investment 
banker $2,000,000 for due diligence costs with respect to the potential 
merger with W, $1,000,000 of which relates to services performed on or 
after March 10, 2005.
    (ii) Y's $500,000 payment for inherently facilitative costs and Y's 
$1,000,000 payment for due diligence activities performed on or after 
March 10, 2005 (the date the letter of intent with W is entered into) 
facilitate the potential merger with W. Because Y could not merge with 
both W and Z, under paragraph (c)(8) of this section the $500,000 and 
$1,000,000 payments also facilitate the transaction between Y and Z. 
Accordingly, Y must capitalize the $500,000 and $1,000,000 payments as 
amounts that facilitate the transaction with Z.
    (iii) Similarly, because Y could not merge with both W and Z, under 
paragraph (c)(8) of this section the $10,000,000 termination payment 
facilitates the transaction between Y and Z. Accordingly, Y must 
capitalize the $10,000,000 termination payment as an amount that 
facilitates the transaction with Z.
    Example 14. Break-up fee; transactions not mutually exclusive. N 
corporation and U corporation enter into an agreement under which U 
would acquire all the stock or all the assets of N in exchange for U 
stock. Under the terms of the agreement, if either party terminates the 
agreement, the terminating party must pay the other party $10,000,000. U 
decides to terminate the agreement and pays N $10,000,000. Shortly 
thereafter, U acquires all the stock of V corporation, a competitor of 
N. U had the financial resources to have acquired both N and V. U's 
$10,000,000 payment does not facilitate U's acquisition of V. 
Accordingly, U is not required to capitalize the $10,000,000 payment 
under this section.
    Example 15. Corporate reorganization; initial public offering. Y 
corporation is a closely held corporation. Y's board of directors 
authorizes an initial public offering of Y's stock to fund future 
growth. Y pays $5,000,000 in professional fees for investment banking 
services related to the determination of the offering price and legal 
services related to the development of the offering prospectus and the 
registration and issuance of stock. The investment banking and legal 
services are performed both before and after board authorization. Under 
paragraph (a)(8) of this section, the $5,000,000 is an amount paid to 
facilitate a stock issuance.
    Example 16. Auction. (i) N corporation seeks to dispose of all of 
the stock of its wholly owned subsidiary, P corporation, through an 
auction process and requests that each bidder submit a non-binding 
purchase offer in the form of a draft agreement. Q corporation hires an 
investment banker to assist in the preparation of Q's bid to acquire P 
and to conduct a due diligence investigation of P. On July 1, 2005, Q 
submits its draft agreement. On August 1, 2005, N informs Q that it has 
accepted Q's offer, and presents Q with a signed letter of intent to 
sell all of the stock of P to Q. On August 5, 2005, Q's board of 
directors approves the terms of the transaction and authorizes Q to 
execute the letter

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of intent. Q executes a binding letter of intent with N on August 6, 
2005.
    (ii) Under paragraph (e)(1) of this section, the amounts paid by Q 
to its investment banker that are not inherently facilitative and that 
are paid for activities performed prior to August 5, 2005 (the date Q's 
board of directors approves the transaction) are not amounts paid to 
facilitate the acquisition of P. Amounts paid by Q to its investment 
banker for activities performed on or after August 5, 2005, and amounts 
paid by Q to its investment banker that are inherently facilitative 
amounts within the meaning of paragraph (e)(2) of this section are 
required to be capitalized under this section.
    Example 17. Stock distribution. Z corporation distributes natural 
gas throughout state Y. The federal government brings an antitrust 
action against Z seeking divestiture of certain of Z's natural gas 
distribution assets. As a result of a court ordered divestiture, Z and 
the federal government agree to a plan of divestiture that requires Z to 
organize a subsidiary to receive the divested assets and to distribute 
the stock of the subsidiary to its shareholders. During 2005, Z pays 
$300,000 to various independent contractors for the following services: 
studying customer demand in the area to be served by the divested 
assets, identifying assets to be transferred to the subsidiary, 
organizing the subsidiary, structuring the transfer of assets to the 
subsidiary to qualify as a tax-free transaction to Z, and distributing 
the stock of the subsidiary to the stockholders. Under paragraph (c)(3) 
of this section, Z is not required to capitalize any portion of the 
$300,000 payments.
    Example 18. Bankruptcy reorganization. (i) X corporation is the 
defendant in numerous lawsuits alleging tort liability based on X's role 
in manufacturing certain defective products. X files a petition for 
reorganization under Chapter 11 of the Bankruptcy Code in an effort to 
manage all of the lawsuits in a single proceeding. X pays its outside 
counsel to prepare the petition and plan of reorganization, to analyze 
adequate protection under the plan, to attend hearings before the 
Bankruptcy Court concerning the plan, and to defend against motions by 
creditors and tort claimants to strike the taxpayer's plan.
    (ii) X's reorganization under Chapter 11 of the Bankruptcy Code is a 
reorganization within the meaning of paragraph (a)(4) of this section. 
Under paragraph (c)(4) of this section, amounts paid by X to its outside 
counsel to prepare, analyze or obtain approval of the portion of X's 
plan of reorganization that resolves X's tort liability do not 
facilitate the reorganization and are not required to be capitalized, 
provided that such amounts would have been treated as ordinary and 
necessary business expenses under section 162 had the bankruptcy 
proceeding not been instituted. All other amounts paid by X to its 
outside counsel for the services described above (including all amounts 
paid to prepare the bankruptcy petition) facilitate the reorganization 
and must be capitalized.

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

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