Final Regs. on Capitalization of Intangibles

The IRS has recently issued Sec. 263(a) final regulations (TD 9107) to explain deducting versus capitalizing amounts paid to acquire or create intangible assets, effective for amounts paid or incurred after 2003. The final regulations made some modifications to 2002 proposed regulations.

Four classes of expenditures require capitalization under Regs. Sec. 1.263(a)-4(b)amounts paid to:

1. Acquire or create an intangible;

2. Create or enhance a separate and distinct intangible;

3. Create or enhance a future benefit identified in published guidance as an intangible requiring capitalization under Sec. 263(a); and

4. Facilitate the acquisition or creation of an intangible described in Regs. Sec. 1.263(a)-4(b)(3).

Definitions

Regs. Sec. 1.263(a)-4(c)(1) defines acquired intangibles as amounts paid for items such as ownership interests in a corporation, partnership, etc.; debt instruments; leases or patents; and other Sec. 197 intangibles, such as goodwill. Under Regs. Sec. 1.263(a)-4(d)(1), created intangibles are amounts paid for the creation, origination or negotiation of a financial interest, such as an ownership interest in a corporation, partnership, etc., debt instrument or credit agreement. They also include prepaid expenses.

According to Regs. Sec. 1.263(a)-4(b)(3), a separate and distinct intangible is one (1) with ascertainable and measurable value, (2) subject to protection under law and (3) for which possession and control can be sold, transferred or pledged. The following items may appear to create a separate and distinct intangible, but need not be capitalized, under Regs. Sec. 1.263(a)-4(b)(3)(iii) and (v):

1. Payments in performance of services under an agreement;

2. Payments for the development of computer software (although this may be capitalized under other published guidance); and

3. Payments to develop a package design.

Future Benefits

In INDOPCO, Inc., 503 US 79 (1992), the Supreme Court held that expenses that produce significant future benefits must be capitalized, even if they do not create or enhance separate and distinct assets. The new regulations help define the significant future benefits standard. If an expense is not otherwise required to be capitalized by the regulations, it is not required to be capitalized solely because it produces future benefits, unless other published guidance specifies a capital requirement.

Amounts paid to facilitate the acquisition or creation of an intangible are generally referred to as transaction costs, which, under Regs. Sec. 1.263(a)-4(e), includes amounts paid to investigate or otherwise pursue a transaction. The fact that an amount would or would not have been paid but for the transaction is relevant, but not determinative. Under Regs. Sec. 1.263(a)-4(e)(1)(ii), an amount paid to terminate an agreement does not facilitate the acquisition or creation of another agreement, unless it results in renegotiation of an existing agreement (in which case, it must be capitalized).

Certain types of expenditures may be interpreted as transaction costs, but have always been understood to be deductible, such as expenses to expand a business, rather than to facilitate a particular transaction. Under Regs. Sec. 1.263(a)-4(e)(1)(iii), amounts paid before the earlier of the date the taxpayer begins preparing a contract bid or begins negotiation of the contract with another party to it are currently deductible.

Compensation

According to Regs. Sec. 1.263(a)-4(e)(4)(i), employee compensation and overhead costs do not facilitate the acquisition or creation of an intangible. For this purpose, employee compensation includes, under Regs. Sec. 1.263(a)-4(e)(4)(ii), bonuses, commissions, guaranteed payments to partners, payments to a corporate director, corporate payments to an employee of an affiliated corporation with which a consolidated Federal return is filed and payments to outside contractors for secretarial, clerical or similar administrative support services.

De Minimis Rule

Further, a de minimis rule under Regs. Sec. 1.263(a)-4(e)(4)(iii) provides that costs, other than employee compensation and overhead, paid in pursuing a transaction and not exceeding $5,000, do not have to be capitalized, on a transaction-by-transaction basis. A taxpayer that reasonably expects to enter into at least 25 similar transactions during a tax year may establish a pool of similar transactions in determining the costs paid in pursuit of transactions in the pool.

Although deducting overhead and employee compensation, as well as de minimis costs, is normally the easiest and most beneficial method, Regs. Sec. 1.263(a)-4(e)(4)(iv) allows an election to capitalize, if desired.

Prepaid Expenses

Under Regs. Sec. 1.263(a)-4(f), taxpayers need not capitalize certain expenditures that only create short-term benefits of 12 months or less. After U.S. Freightways, 270 F3d 1137 (7th Cir. 2001), this rule now confirms the deductibility of intangibles, such as one-year insurance policy premiums and one-year fees or licenses for rights (e.g., state truck registrations). The rule does not require capitalization of amounts paid to create a benefit that does not extend beyond the earlier of 12 months after the first date on which the taxpayer realizes the benefit, or the end of the tax year following the tax year in which the payment is made.

According to Regs. Sec. 1.263(a)-4(f)(iii), this rule does not apply to the creation of financial interests or amortizable Sec. 197 intangibles, nor does it affect the determination of whether economic performance has occurred. Under Regs. Sec. 1.263(a)-4(f)(vi), an accrual-method taxpayer must still wait until a liability is incurred before capitalizing or deducting prepayments. The Sec. 461 economic performance rules still apply; an accrual-method taxpayer cannot take prepaid amounts for goods and services into account until they are provided. For example, an accrual-basis taxpayers rent prepayment for the first six months of the following tax year will not meet the economic performance test. Rent is payment for use of property over a specific period and is not incurred until the tax year for which paid.

Under Regs. Sec. 1.263(a)-4(f)(iv) and (v), the 12-month rule also does not apply to amounts paid to create an intangible of indefinite duration, such as a license to conduct business granted by a government agency. Although such a license may be renewable periodically, it is deemed of indefinite length as long as it is reasonable to expect that the renewal will be granted.

Finally, certain payments that may only have value of 12 months are not deductible if the value does not start during the current tax year. For example, an annual insurance premium paid by a calendar-year corporation in December 2004 for a policy with a term beginning in February 2005 must be capitalized, because the benefit attributable to the payment extends beyond the end of the following tax year.

On another note, cash-basis taxpayers not subject to the economic performance rules may be subject to capitalization under Sec. 263 and the regulations. Such taxpayers may also be subject to other published guidance and case law that do not allow for prepayment deductions when no business purpose exists for the prepayment.

Compliance

Regs. Sec. 1.263(a)-4(p) provides that taxpayers can take advantage of the automatic accounting-method change procedures under Rev. Proc. 2002-9 by attaching Form 3115, Application for Change in Accounting Method, to a timely filed return (including extensions). A second copy of Form 3115 should be filed with the IRS National Office. For prepaid expenses, a Sec. 481(a) adjustment will generally allow immediate deduction for calendar-year 2003 returns, under the modified cut-off method.

From Laura Jagdman, CPA, MST, Timonium, MD