Understanding the Capitalization Regulations

Authors: Robert Feinschreiber and Margaret Kent
Publication Date: March 06, 2003

Understanding the Capitalization Regulations
By Robert Feinschreiber and Margaret Kent, Attorneys and Counselors

The Department of the Treasury and Internal Revenue Service issued proposed capitalization regulations on December 19, 2002 that would, in some instances, ultimately force taxpayers to capitalize certain expenditures that the taxpayer would otherwise deduct. These regulations, if promulgated, would impact the amounts that a business pays to acquire, create, or enhance intangible assets. These proposed capitalization regulations are extensive in scope and in content, effecting most capitalization issues that a business might face.

This analysis provides a preview of the proposed capitalization regulations issued under section 1.263(a)-4. This analysis does not provide an in-depth specific analysis of each capitalization provision; instead, the article suggests avenues to be followed later. Readers of these regulations are cautioned that they need to carefully examine the examples in these regulations, as these examples go beyond the confines of the regulatory language.

Taxpayers can be part of the regulatory process by submitting comments to CC:ITA:RU (REG-125638-01), room 5226, Internal Revenue Service, POB, 7064, Ben Franklin Station, Washington D.C. 20044 by March 19, 2003. Alternatively, taxpayer can submit these comments electronically at http://www.irs.gov/regs. A public hearing is scheduled for April 22, 2003. Taxpayers seeking to speak concerning these proposed regulations can do so by submitting the request to speak and an outline of topics by April 1, 2003.

Background

The Department of the Treasury and Internal Revenue Service issued these proposed capitalization regulations ostensibly to resolve the debate as to the extent to which taxpayers must capitalize intangible amounts under Section 263(a). This debate affected amounts that the taxpayer had paid to acquire, create, or enhance intangible assets. The Department of the Treasury and the IRS sought to "provide certainty" and to create categories that "will help promote consistent application of section 263(a) by taxpayers and IRS field personnel." The preamble to the regulation acknowledges that the IRS and the Treasury Department "considered" expenditures for which the courts have traditionally required capitalization. We caution that the term "considered" differs from the term "acted in a manner that is consistent with."

In light of the importance of these capitalization provisions, the Department of the Treasury and the IRS had issued an advance notice of proposed rulemaking in the Federal Register, 67 FR 3461, on January 24, 2002, which invited public comment. The Treasury and the IRS, in preparing these proposed capitalization regulations, modified their capitalization approach in partial response to this public comment. Nevertheless, despite the government's assertion that the purpose of these regulations was to lessen the expense-capitalization debate, it is our view that the IRS designed these regulations primarily as a revenue-raiser for the government. It is our view that the expense-capitalization debate will continue after the regulatory process is completed, but perhaps with both sides better armed.

Outline of the Proposed Regulation

The proposed capitalization regulations and the preamble to these proposed capitalization regulations are complex, as these provisions often address various rationales that explain why expenditures might or might not be capitalized. Given the complexity of the preamble to these regulations, it may be useful to view the preamble in outline format:
I. Introduction
II. General Principle of Capitalization
A. Overview
B. Separate and Distinct Intangible Asset
C. Significant Future Benefits Identified in Published Guidance
III. Intangibles Acquired From Another Party
IV. Created Intangibles
A. Financial Interests
B. Prepaid Expenses
C. Amounts Paid to Obtain Certain Memberships and Privileges
D. Amounts Paid to Obtain Certain Rights
E. Amounts Paid to Obtain of Modify Contract Rights
F. Amounts Paid to Terminate Certain Contracts
G. Amounts Paid to Acquire, Produce, or Improve Real Property Owned by Another Party
H. Amounts Paid to Defend or Perfect Title to Intangible Property
V. Transaction Costs
A. In General
B. Facilitate
C. Hostile Takeover Defense Costs
D. Simplification Conventions Applicable to Transaction Costs
VI. 12-Month Rule
A. In General
B. Application of the 12-Month Rule to Contract Termination
C. Rights of Indefinite Duration
D. Rights That Are Renewable
VII. Safe Harbor Amortization
A. In General
B. Restructurings, Reorganizations and Transactions Involving the Acquisition of Capital
VIII. Computer Software Issues
IX. Proposed Effective Date

General Capitalization Principles

Overview

The proposed capitalization regulations enunciate a general capitalization principle under Section 263(a)-4 that would require the taxpayer to capitalize certain amounts. Capitalization would apply when the taxpayer pays for the following amounts:

• Amounts paid to acquire intangible assets

• Amounts paid to create intangible assets, or

• Amounts paid to enhance intangible assets.
  

The proposed capitalization regulations would identify specific intangible
assets that the taxpayer must capitalize under the above "general principle." The regulations organize these identified intangible assets into two groups, based on the following:
· whether the taxpayer acquires the intangible assets from another party, or
· whether the taxpayer creates the intangible asset.

The proposed capitalization regulations would address transaction costs,
which are of two types:

• transaction costs that facilitate the acquisition, creation, or enhancement of intangible assets

• transactions that facilitate certain restructurings, reorganizations, and transactions involving the acquisition of capital.

The proposed capitalization regulations would provide two ostensibly taxpayer-friendly provisions:

• a simplifying convention intended to promote administrability and to reduce compliance with section 263(a) by excluding employee costs and overhead

• a safe harbor amortization period of 15 years under section 1.167-3(b) that would be applicable to certain created intangible assets that do not have readily ascertainable useful lives

Definitions of Intangible Assets

The proposed capitalization regulations would define "an intangible asset" in the following manner so as to include:

1. purchased intangibles - any intangible that is acquired from another person in a purchase or in a similar transaction under section 1.263(a)-4(b)(2)(i)(A), as defined by section 1.263(a)-4(c) of the proposed capitalization regulations,

2. origination intangibles - certain rights, privileges, or benefits that are originated by the taxpayer under section 1.263(a)-4(b)(2)(i)(B) and identified in section 1.263(a)-4(d) of the proposed capitalization regulations,

3. a separate and distinct intangible asset under section 1.263(a)-4(b)(2)(i)(C), as defined by section 1.263(a)-4(b)(3) of the proposed capitalization regulations, and

4. a future benefit under section 1.263(a)-4(b)(2)(i)(D), specifying that the IRS and the Treasury Department are to identify, in subsequent published guidance, an intangible asset for which capitalization is required.

Separate and Distinct Intangible Asset

As a general matter, the courts seek to ascertain whether an expenditure serves to acquire, create, or enhance a separate and distinct asset that would be subject to being capitalized. The proposed capitalization regulations under section 1.263(a)-4(b)(3)(i) are said to reflect three court- imposed parameters that would ascertain whether an intangible asset is separate and distinct:
1. whether the expenditure creates a distinct and recognized property interest that is subject to protection under state and federal law,
2. whether the expenditure creates anything that is transferable or salable.
3. whether the expenditure creates anything with an ascertainable and measurable value in money's worth.

The proposed capitalization regulations specify that the "separate and distinct" determination is to be made of the taxable year in which the amount is paid, without the benefit of hindsight. The drafters presumably intend that this lack of clairvoyance would apply equally to taxpayers and the IRS. Nevertheless, the regulations fall short of requiring the taxpayer to maintain contemporaneous documentation. We suggest that taxpayers consider voluntarily undertaking this contemporaneous documentation process as a means of proving the "separate and distinct" determination.

Future Benefits

The preamble to the capitalization regulations viewed INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992), as standing for capitalization treatment when a taxpayer incurs an expenditure that produces a "significant future benefit." Now, more than ten years after the Supreme Court decided INDOPCO, the regulatory drafters recognized that the "significant future benefit" standard "does not provide the certainty and clarity necessary…" The IRS and Treasury recognized that restating the significant future interest test, without more, would lead to "continued uncertainty."

Accordingly, the IRS and Treasury have "initially defined the exclusive scope of the significant future benefit test though the specific categories of intangible assets for which capitalization is required in the proposed regulations." In other words, the IRS and the Treasury have sought to preempt the "significant future benefit standard" by defining these standards for their own benefit, by their own enumeration of intangible assets. The IRS and the Treasury promise (or threaten) to provide future guidance that will determine whether capitalization is appropriate for a particular category of expenditures.

Intangibles Acquired From Another

As a general rule, the proposed capitalization regulations would require the taxpayer to capitalize amounts that the taxpayer pays to another party to acquire an intangible from that party in a purchase or in a similar transaction. These provisions are contained in section 1.263-4(c) in the proposed capitalization regulations. The drafters of the regulation make clear that the purchase price includes sales taxes and similar taxes. As a result of that determination, the IRS and the Treasury do not view sales taxes and similar taxes as transaction costs, but as part of intangible acquisition. The proposed capitalization regulations would treat transaction costs as a separate matter from the cost of acquiring intangibles from another party.

Many of these capitalized intangibles might include amortizable section 197 intangibles. The proposed capitalization regulations provide specific provisions for intangibles that the taxpayer acquired from another party, as distinct from created intangibles. Section 1.263-4(c)(1) contains an extensive list of acquired intangibles.

Created Intangibles

The proposed capitalization regulations would require the taxpayer to capitalize amounts paid to another party to create or enhance certain identified intangibles pursuant to section 1.263-4(d) in the proposed capitalization regulations. However, a 12-month expense rule would apply to most created intangibles so as to exclude the capitalization of these created intangibles because of this 12-month rule. This created intangible provision would not apply to acquired intangibles or to transaction costs.

Financial Interests

The proposed capitalization regulations would require taxpayers to capitalize amounts paid to create or to originate certain financial interests with that party pursuant to section 1.263-4(d)(2) in the proposed capitalization regulations. The "financial interests" term, to which the proposed regulations have reference, are principally of two types, entities and financial instruments, which are delineated as follows:

• Entities - such as corporations, partnerships, or trusts, for example, as specified under section 1.263-4(d)(2)(i)(A) in the proposed capitalization regulations

• Financial instruments - such as debt instruments, notational principal contracts, or options, for example, as specified under section 1.263-4(d)(2)(i)(C) in the proposed capitalization regulations

The 12-month expense rule generally applies to created intangibles. Nevertheless, despite the fact that the proposed capitalization regulations would treat financial interests as created intangibles, the 12-month expense rule does apply to amounts paid or enhance a financial interest described in this regulation.

Prepaid Interests

The proposed capitalization regulations would require the taxpayer to capitalize amounts prepaid for benefits to be received in the future, as specified under section 1.263-4(d)(3) in the proposed capitalization regulations. The prepaid interests provision applies to services or to other benefits, such as insurance, to be received in the future. This prepaid interests provision does not impact the prepaid amounts that a taxpayer might expend for the acquisition of tangible property.

Amounts Paid to Obtain Certain Memberships and Privileges

The proposed capitalization regulations would require taxpayers to capitalize amounts paid to an organization to obtain or renew a membership or privilege from that organization, pursuant to section 1.263-4(d)(4) in the proposed capitalization regulations. This capitalization provision would not apply to quality certifications. It our view that the IRS and Treasury overreached in setting up the capitalization requirement for membership renewals, and that the regulations should allow the taxpayer to expense initial membership costs under the de minimis provisions.

Amounts Paid to Obtain Certain Rights from a Governmental Agency

The proposed capitalization regulations would require taxpayers to capitalize amounts paid to a governmental agency pursuant to section 1.263-4(d)(5) in the proposed capitalization regulations. Such payments include the following: trademark, trade name, copyright, license, franchise, or similar right granted by that governmental agency. This capitalization provision is generally directed at the initial payment to the governmental agency, not to renewal fees to that agency. This capitalization provision does not preempt other tax provisions, including the treatment of patent application fees.

Amounts Paid to Obtain or Modify Contract Rights

The proposed capitalization regulations would require taxpayers to capitalize two types of contract rights pursuant to section 1.263-4(d)(6) in the proposed capitalization regulations:

1. rights that are "reasonably certain to produce future benefits," and

2. benefits for which the courts have traditionally required capitalization

The preamble to the proposed regulations specifies that the regulations would require capitalization in the following instances:

1. amounts paid to enter a lease contract or renegotiate a lease contract.

2. 2. a contract that provides the taxpayer the right to acquire or provide services.

3. 3. amounts paid to obtain a covenant not to compete.

The proposed capitalization regulations delineate actual performance from forbearance. These regulations would require the taxpayer to capitalize amounts in the context of a covenant not to compete, but would not require the taxpayer to capitalize amounts in the context of personal services contracts if the contract pertains to services actually rendered.

The proposed regulation would require the taxpayer to capitalize rights that are "reasonably certain" to produce future benefits. In contrast, the regulations do not require the taxpayer to capitalize amounts when these rights are merely "an expectation" that the customer or supplier will maintain its business relationship with the taxpayer. In addition, the proposed regulation includes a $5,000 de minimis exception for contract rights. Nevertheless, the regulations might require the taxpayer to capitalize amounts under the financial interests rule or under the contract rights provisions.

Amounts to Terminate Certain Contracts

The proposed capitalization regulations would require taxpayers to capitalize contract termination payments in three contractual situations pursuant to section 1.263-4(d)(7) in the proposed capitalization regulations. The proposed regulations view the taxpayer as reacquiring a valuable right that the taxpayer did not possess immediately prior to contract termination:

1. payments made by a lessor to terminate the lease agreement with a lessee pursuant to section 1.263-4(d)(7)(i)(A) in the proposed capitalization regulations.

2. payments made to terminate an agreement that provides another party with the exclusive right or use of the taxpayer's property or services pursuant to section 1.263-4(d)(7)(i)(B) in the proposed capitalization regulations.

3. Payments made to terminate an agreement that prohibits the taxpayer from competing with another party or that prohibits the taxpayer from acquiring property or services from a competitor of another party pursuant to section 1.263-4(d)(7)(i)(C) in the proposed capitalization regulations.

The proposed regulations specify that the contract termination provisions would not apply to the following payments:

1. payments to terminate a supply contract with a supplier

2. payments made by the lessee to capitalize a payment to terminate a lease agreement with a lessor

The proposed regulation modified provisions in the advance notice of proposed rulemaking in three respects, expanding the capitalization requirements in each case:

1. the focus is now the treatment of exclusive rights, so that the taxpayer must capitalize amounts paid to terminate an exclusive license to use the taxpayer's property.

2. the advance notice eliminated the "geographic area" requirement.

3. the regulation requires the taxpayer to capitalize amounts paid to another party to terminate an agreement that prohibits the taxpayer from competing with another party.

Amounts Paid to Acquire, Produce, or Improve Real Property Owned by Another Party

The proposed capitalization regulations would require the taxpayer to capitalize amounts paid that would be "reasonably expected to produce significant economic benefits for the taxpayer" in connection with real property in two circumstances pursuant to section 1.263-4(d)(8) in the proposed capitalization regulations:

1.  to acquire real property that is relinquished to another party, or

2. to produce or improve real property that is owned by another party.

This "owned by another" provision in the proposed capitalization regulations requires the taxpayer to capitalize amounts in which one of the following two situations occur:

1. the taxpayer provides property to another party with the expectation that the property will provide significant future benefits to the taxpayer, or

2. the taxpayer improves property owned by another with the expectation that the property will provide significant future benefits to the taxpayer.

The preamble to the proposed capitalization regulations states that the "owned by another" provision reflects case law and rulings. This regulation would require capitalization of the following activities:

1. paving a public road where that taxpayer would benefit from the road,

2. conveyance of land by a railroad which reduces the cost of crossing protection,

3. expenditures for a publicly-owned breakwater whether the business could benefit from this expenditure,

4. building as state-owned highway over the taxpayer's tracks would provide the taxpayer with a long-term business benefit,

5. dredging the public harbor adjacent to the taxpayer's pier.

We suggest the existing case law is flawed to the extent that the facility is genuinely available for public use, regardless of whether the taxpayer is the predominant user of the facility. The drafters of the proposed capitalization regulations support existing law in their favor, and point out that the IRS and Treasury considered, but did not, expand the existing capitalization rule to include other tangible property. It is our belief that the law should allow the deduction if the benefit is available to others.

The proposed regulations would specify a 25-year amortization period. Many taxpayers suggested a conventional recovery period instead, but the IRS and the Treasury rejected that approach. The IRS and Treasury are receptive to the amortization issue.

Amounts Paid to Defend or Perfect Title to Intangible Property

The proposed capitalization regulations would require taxpayers to capitalize an amount paid to another party to defend or protect title to intangible property pursuant to section 1.263-4(d)(9) in the proposed capitalization regulations. Nevertheless, the proposed regulations would not require taxpayers to capitalize amounts paid to protect the intangible property against infringement or similar claims. Infringement claims would remain deductible.

Transaction Costs

The proposed capitalization requirements would require taxpayers to capitalize transaction costs pursuant to section 1.263-4(e) in the proposed capitalization regulations under either of two principles:

1. Transaction costs that would facilitate the taxpayer's acquisition, creation, or enhancement of an intangible asset.

2. Transaction costs that would facilitate the taxpayer's restructuring or reorganization of a business entity, or the transaction involving the acquisition of capital, including a stock issuance, borrowing or recapitalization.

The first prong of the transaction cost rule addresses the acquisition, creation, or enhancement of an intangible asset. This transaction cost rule recognizes that the taxpayer is obligated to capitalize the following amounts:

1. the cost of the asset itself, and

2. the ancillary expenditures for the acquiring, creating, or enhancing the intangible asset.

The second prong of the transaction cost rule, according to the drafters of the proposed capitalization regulation, would recognize that transaction costs that effect a change in the taxpayer's capital structure "create betterments of a permanent or definite nature." These drafters would treat these transaction costs as appropriately capitalized. These capitalized items would include the following costs:

• professional fees by a target corporation in a stock acquisition,

• costs to issue a stock dividend, and

• professional fees incurred in a recapitalization.

The proposed capitalization regulations use the term "reorganizations" in a broad context, not just in the tax reorganization context. These proposed regulations do not consider changes to an entity's business processes or restructuring as subject to the mandatory capitalization process. In contrast, the proposed capitalization regulations require the taxpayer to capitalize costs to facilitate a divisive transaction, except when the division is pursuant to government mandate.

Facilitate

The proposed capitalization regulations would provide a "facilitate" standard for determining whether the taxpayer must capitalize transaction costs pursuant to section 1.263-4(e)(1) in the proposed capitalization regulations. This "facilitate" standard is intended to be narrower in scope than the "but for" standard. The preamble to the proposed capitalization regulations discusses as examples the cost to downsize a workforce after a corporate merger, including severance payments, and the costs to integrate operations. The drafters assert that the taxpayer might be required to capitalize those expenditures under the "but-for" standard, but that the taxpayer would not have to capitalize those expenditures under the "facilitate" standard.

A number of taxpayers have suggested that the Treasury and IRS differentiate "facilitate" costs from investigation costs. The proposed regulations would require capitalization of these expenditures only if the activity is "inherently facilitative" or that the amount incurred relates to activities performed after the earlier of the following dates:

1. the date that a letter of intent or similar communication is issued

2. the date that the taxpayer's Board of Directors approves the acquisition proposal.

Amounts that are "inherently facilitative" include the following activities:

1. determining the value of a target

2. drafting transactional documents

3. conveying property between the parties.

Nevertheless, the authors suggest that the "inherently facilitative" standard is overreaching, both as to valuation activity and the conveying activity. The authors suggest that valuation may be part of early evaluation process prior to the selection of the target, and it would be better to treat the valuation activity as an investigation cost. The authors suggest the conveying is too broadly based, and the conveying activity might, or might not, potentially add to value of the enterprise, depending on the circumstances.

Hostile Takeover Defense Costs

The proposed capitalization regulations would provide that transaction costs that are incurred by a taxpayer to defend itself against a hostile takeover do not "facilitate" the acquisition. As a result, the taxpayer should not be required to capitalize these defense costs. The drafters, however, are concerned that a hostile takeover attempt can become friendly. In that event, the taxpayer is obligated to bifurcate its costs between hostile defense costs, which are deductible, and facilitative costs, which the taxpayer must capitalize. The proposed regulations would require that the taxpayer capitalize all dual use costs, including the cost of undertaking "white knight" mergers.

Simplified Conventions Applicable to Transaction Costs - Salaries and Overhead

The proposed capitalization regulations would allow the taxpayer to deduct all employee compensation, whether paid in the form of salary, bonus or commission pursuant to section 1.263-4(e)(3)(i) in the proposed capitalization regulations. In addition, the taxpayer can treat fixed overhead and variable overhead as deductible. The preamble to the proposed capitalization regulations portrays these rules as rules of administrative convenience, not substantive rules of law. Nevertheless, these rules would provide significant benefits for a number of taxpayers. The Treasury and IRS are contemplating a rule that would require book-tax conformity, and taxpayers may choose to comment on that contemplation.

Simplified Conventions Applicable to Transaction Costs - De Minimis Costs

The proposed capitalization regulations would provide that de minimis transaction costs do not facilitate a capital transaction, and that the taxpayer need capitalize these amounts pursuant to section 1.263-4(e)(3)(ii) in the proposed capitalization regulations. De minimis costs are amounts that do not exceed $5,000. The de minimis rule is not designed as an exclusion from capitalization amounts, so that the de minimis rule does not apply partially to capitalization amounts that exceed $5,000.

A taxpayer would be able to make use of the de minimis rule by pooling similar transactions. This de minimis rules does not apply to commissions paid to acquire or create financial interests, so that the proposed regulations would require the taxpayer to capitalize all commissions concerning financial interests.
The proposed regulations, as constituted, do not address the differentiation between recurring and nonrecurring expenditures for capitalization purposes.

Twelve Month Expense Provision

Existing regulations require the taxpayer to capitalize expenditures that "create an asset" where the asset has "a useful life substantially beyond the close of the taxable year. Expenditures that do not meet this requirement could remain deductible. Some courts apply a "one-year" rule in determining whether an asset has a useful life that is substantially beyond the close of the taxable year.

The proposed capitalization regulations would adopt this capitalization rule in the context of a "12 month rule" pursuant to section 1.263-4(f)(1) in the proposed capitalization regulations. A taxpayer that acquires assets that have a useful life beyond the 12 months must capitalize these amounts in full. The proposed regulations would not apply the twelve-month rule to financial interests or to self-created section 197 intangibles.

The authors suggest the drafters have failed in part to apply the one-year rule. We suggest that the expense rule should be based on duration of less than one year, determined as of the end of the year rather than the date of the expenditure. Taxpayers will find it difficult to apply this capitalization concept on a monthly basis under the 12-month rule. Assuming that the business in acquiring "assets" evenly throughout the year, the method we suggest would require capitalization of assets with a useful life of more than 1 ½ years on average.

Application of 12-Month Rule to Contract Terminations

The proposed capitalization regulations would clarify that the termination of a contract takes place at the termination date for purposes of the 12-month rule pursuant to section 1.263-4(f)(2) in the proposed capitalization regulations. The benefit to the taxpayer is equal to the unexpired term of the agreement as of the date of termination. The 12-month rule would apply if the unexpired term is less than 12-months.

Rights of Indefinite Duration

The 12-month rule does not apply to contracts or to other rights that are indefinite in duration pursuant to section 1.263-4(f)(4) in the proposed capitalization regulations. Facts or the law can determine that the rights are of infinite duration. Such rights are not based on a period of time, but are based on a right to provide or receive a fixed amount of goods or services. However, the taxpayer can amortize the amounts.

Rights that are Renewable

The proposed capitalization regulations provide rules for determining whether the taxpayer must take renewal periods into account pursuant to section 1.263-4(f)(5) in the proposed capitalization regulations, specifying that the taxpayer is to take renewal periods into account if there is a "reasonable expectancy of renewal." Taxpayers had suggested the appropriate standard should be "substantial likely" or economically compelled, " but the IRS and Treasury rejected this approach. The IRS and Treasury are considering applying rules that would permit taxpayers to pool these transactions for purposes of the 12-month rule.

Safe Harbor Amortization

The proposed capitalization regulations would amend the existing amortization provisions under section 1.167(a)-3 for certain created or enhanced intangibles that do not have readily ascertainable useful lives. These modifications would be reflected as section 1.167(a)-3(b), specifying amortization over a 15-year period. The drafters of the proposed capitalization regulations seek to include certain memberships and privileges of infinite duration within the scope of this provision.

Taxpayers suggested a five-year amortization rule, but the IRS and the Treasury rejected their approach. The authors believe that individual taxpayers, such as doctors, attorneys, farmers, and engineers should have the option to use amortization for these expenditures based on her or his life expectancy or retirement. These amortization provisions would not apply to created intangibles that have useful lives or to prepaid expenses.

Restructuring, Reorganizations, and Transactions Involving the Acquisition of Capital

The proposed capitalization regulations would not provide safe harbor amortization for capitalized transaction costs where:

1. these costs facilitate a stock issuance pursuant to section 263(a)-4(g)(1) of the proposed capitalization requirements, or

2. these costs facilitate other transactions involving the acquisition of capital pursuant to section 263(a)-4(g)(2) of the proposed capitalization requirements.

The proposed capitalization regulations would treat both stock issuance
costs and costs that facilitate a recapitalization as reduction in capital proceeds, not as creating a separate intangible asset. This regulation would follow prior treatment. The proposed capitalization regulations do not allow safe harbor amortization for capitalized transaction costs that facilitate a restructuring or reorganization of a business entity.

The safe harbor provisions within the proposed capitalization regulations do not apply to transaction costs properly capitalized by an acquiror to facilitate the acquisition of stock or assets of a target corporation in a taxable acquisition. The proposed regulations specify that the capitalized transaction costs generally can be recovered in the case of an asset acquisition. The drafters fail to address, however, the practicalities of adding these amounts to basis for what may be millions of assets.

The safe harbor provisions within the proposed capitalization regulations do not apply to transaction costs properly capitalized by a target to facilitate the acquisition of its assets by an acquiror in a taxable acquisition. In this case, the transaction costs are offset against the gain or loss recognized by the target of the disposition of the assets. The IRS and the Treasury are contemplating adding safe harbor amortization in this situation, and are requesting comments.

A number of threshold issues exist regarding the proper treatment of capitalized costs in determining whether the safe harbor amortization provisions apply to transaction costs that facilitate a tax-free acquisition:

1. Should the acquiror add the cost to basis, and should the acquiror be precluded from amortizing these costs?

2.  Should the target's capitalized transaction costs be treated as a separate intangible?

3. . Should a target's capitalized transaction costs be viewed as an intangible asset with an indefinite useful life, as a reduction in the amount realized, or as an increase in the target's basis?

4. Should amortization be permitted if a target's capitalized transaction costs are viewed as an intangible asset with an indefinite useful life?

5. Should the safe harbor provisions apply to capitalized transaction costs other than acquisitive transactions, such as corporate formations or corporate divisions?

Existing law requires that capitalized transaction costs incurred to borrow money be deducted over the term of the debt. The proposed regulations would require taxpayers to use a constant yield method under proposed section 1.446-5.

Computer Software Issues

The regulation project put these computer software issues aside for a future regulations project.

Proposed Effective Date

The proposed capitalization regulations, if promulgated, will become effective on the date that the final regulations are published in the Federal Register. Taxpayers are not permitted to adopt these regulations prior to promulgation. In addition, taxpayers must follow the change in accounting procedures. The IRS and the Treasury are requesting comments on look-back issues and recordkeeping burdens.