INDOPCO Coalition Proposed Capitalization Principles

PROPOSED CAPITALIZATION PRINCIPLES

A. Overview. These principles provide guidance for identifying costs that must be capitalized under section 263.

B. Capitalization requirement.

1. General rule. Taxpayers must capitalize costs as provided below in Part II (relating to acquisition, creation, organization, reorganization, and new separate trade or business investigation and creation transactions ("ACORN Transactions")), Part III (relating to business operations), and Part IV (relating to repairs and capital improvements).

2. Definition. Capitalize means to charge to a capital account or basis.

3. Timing. The amount of any cost may not be charged to capital accounts or basis any earlier than the taxable year during which the amount is incurred within the meaning of section 1.446-1(c)(1)(ii).

4. Otherwise deductible.

a. In general. Any cost that (but for the capitalization requirement) may not be taken into account in computing taxable income for any taxable year is not a cost required to be capitalized under these principles for the taxable year.

b. Example. An accrual basis corporation incurs costs for services to be provided in future taxable years with respect to corporate acquisition transactions. Under section 461(h), economic performance with respect to the costs has not occurred at the end of the taxable year. As a result, the costs (without regard to the capitalization requirement) may not be taken into account in computing taxable income for the taxable year and therefore are not costs required to be capitalized under these principles for the taxable year.

C. Scope. These principles do not apply to items, either transactions or costs, the tax treatment of which is specifically governed by other provisions in the Code or regulations, ¹ including, for example:

1. Section 163 (interest);

2. Section 164 (taxes);

3. Section 165 (losses);

4. Section 167 (depreciation);

5. Section 168 (accelerated cost recovery system);

6. Section 173 (circulation expenditures);

7. Section 174 (research and experimental expenditures);

8. Section 175 (conservation expenditures);

9. Section 178 (amortization of cost of acquiring a lease);

10. Section 179 (election to expense certain depreciable assets);

11. Section 195 (start-up expenditures);

12. Section 197 (amortization of goodwill and certain other intangibles);

13. Section 248 (amortization of organizational expenditures);

14. Section 263A (capitalization of costs of producing real property or tangible personal property or acquiring inventory);

15. Section 460 (long-term contracts);

16. Section 461 (general rule for taxable year of deduction);

17. Section 467 (certain payments for the use of property or services);

18. Section 468A and Section 468B (nuclear decommissioning costs and designated settlement funds);

19. Section 471 (general rules for inventories); and

20. Section 848 (capitalization of certain policy acquisition expenses).

II. ACORN Transactions. As set forth in Part I.B.1. above, ACORN transactions include acquisition, creation, organization, reorganization, and new separate trade or business investigation and creation transactions.

A. Capitalization requirement. Taxpayers must capitalize (i) consideration paid in an ACORN Transaction (including the principal component of any debt acquired or assumed) and (ii) transaction costs of accomplishing or consummating an ACORN Transaction.

B. Types of ACORN Transactions. The following are ACORN Transactions:

1. Acquiring stock of a corporation conducting a trade or business, an ownership interest in a non-corporate entity conducting a trade or business, or assets of a trade or business in a taxable or non-taxable transaction; ²

2. Creating, organizing, or reorganizing an entity, including:

a. Planning and establishing the organizational structure of a new entity;

b. Raising capital and issuing debt, stock or other equity interests;

c. Listing an entity's stock or other equity interests on a stock exchange; and

d. Reorganizing an entity's capital structure; ³ and

3. Entering a new separate trade or business by investigating and creating a new trade or business. ⁴

C. Determining whether a taxpayer is entering a new separate trade or business or expanding an existing trade or business.

1. General rule. For purposes of Part II.B.3., the determination whether a taxpayer in an existing trade or business is entering into a new separate trade or business, on the one hand, or expanding the taxpayer's existing trade or business, on the other hand, is a question of facts and circumstances.

2. Factors. The following factors indicate a continuation of the taxpayer's existing business rather than entry into a new separate trade or business. The determination is based on all of the applicable facts and circumstances. In any given situation, several of the listed factors will be inapplicable. However, the presence of a single factor ordinarily indicates that the taxpayer is not entering into a new trade or business.

The taxpayer's existing business and the created or acquired business:

a. Produce or manufacture one product line, two or more related product lines, or goods serving substantially similar functions;

b. Provide substantially similar or related services;

c. Use substantially similar production or manufacturing processes or similar manner of sales;

d. Use substantially similar equipment and personnel to provide services to customers;

e. Provide goods or services to substantially similar customers;

f. Have a high degree of duplication and overlap in products produced (or sold) at various manufacturing (or sales) facilities;

g. Use substantially similar raw materials in producing or manufacturing goods;

h. Use the same, substantially similar, or complementary technology;

i. Involve an expansion of the scope of the taxpayer's activities within a particular supply chain such as beginning to manufacture a previously purchased component of the taxpayer's historic product or beginning to provide repair and maintenance services for the products historically manufactured by the taxpayer;

j. Use similar production processes (or sales facilities) facilitating the interchange of machinery and personnel across facilities to meet specific needs or to improve overall operations; and

k. If no acquisition is involved, fit within the internal management divisions historically used by the existing trade or business or, if an acquisition is involved, have historically used substantially similar internal management divisions and after the acquisition integrate the matching internal management divisions.

3. Examples.

a. A corporation manufactures, in one division, automatic clothes washers and dryers of both commercial and domestic grade as well as electric ranges and dishwashers. The corporation establishes another division to manufacture radios and television sets. The manufacturing facilities and processes used in manufacturing the radios and television sets are distinct from those used in manufacturing the automatic clothes washers and dryers, electric ranges, and dishwashers. The manufacturing processes, raw materials, and technology are not substantially similar. Under these circumstances, the corporation would be entering into a new separate trade or business.

b. A corporation has a franchise to provide cable television in a specified geographic area. The corporation, using the existing equipment and employees as well as certain additional equipment and employees, begins to provide telephone service, Internet browsing capability, and home security services to the same and similar customers. Under these circumstances, the corporation would be expanding the existing trade or business rather than entering into a new separate trade or business.

c. A corporation manufactures air conditioning units and heat- pump units that employ vapor compression mechanical refrigeration technology to provide cooling and, in the case of heat pumps, heating. The corporation begins to manufacture refrigerators and icemakers that also employ vapor compression mechanical refrigeration technology. Under these circumstances, the corporation would be expanding the existing trade or business rather than entering into a new separate trade or business.

d. A corporation provides cellular telephone services. The corporation upgrades its system to use new, state of the art technology and simultaneously begins to provide Internet browsing capability to its customers. The telephone services provided are substantially similar to the telephone services previously provided. The personnel used to provide services are the same or substantially similar to the personnel previously used to provide services. The technology previously used in providing telephone services is either substantially similar to or complementary to the new, state of the art technology used to provide telephone services and the technology used to provide Internet browsing capability. The corporation uses the same sales facilities for all of its services. Under these circumstances, the corporation would be expanding the existing trade or business rather than entering into a new separate trade or business.

e. A corporation develops and markets computer spreadsheet software. Other entities develop and market add-on software to be used with the corporation's spreadsheet software to provide increased functionality (e.g., more flexible printing, networking, spellchecking). The corporation incorporates this functionality into its spreadsheet software by developing software to provide the functionality provided by the add-on software or acquiring the add- on software developed by the other entities. The corporation's spreadsheet software continues to fit within one product line and the corporation continues to use substantially similar or complementary technology. Under these circumstances, the corporation would be expanding the existing trade or business rather than entering into a new separate trade or business.

f. A corporation operates a garage location that provides basic car repair services such as oil changes. The corporation begins to repair desktop and laptop personal computers and peripheral devices such as printers, either in one portion of the building that houses its garage or at the customer's location. The services, manner of sales, equipment, and personnel are not substantially similar. Under these circumstances, the corporation would be entering into a new separate trade or business.

g. A corporation operates conventional, fossil fuel electric generating facilities. The corporation begins to operate a nuclear generating facility. Employees at the nuclear facility require more training as a result of the dangers to public safety from radiation exposure. The nuclear facility uses a different means to produce heat, requires support systems that are not required at a conventional facility, and requires an operating license issued by the Atomic Energy Commission. The production and manufacturing processes, raw materials, and technology are not substantially similar. However, the underlying product delivered by the taxpayer has not changed and neither have the customers of the taxpayer. The taxpayer also begins to operate a new conventional facility. Although the new conventional facility was larger than the corporation's other conventional facilities and included new features that were not available when the corporation built its other conventional facilities, the new conventional facility was not essentially different in kind from the corporation's other conventional facilities. The corporation would not be entering into a new separate trade or business with respect to either the nuclear facility or the new conventional facility. ⁵

h. A bank offers checking and saving accounts, time deposits, and loans to its customers. The bank begins to offer a nationally branded credit card to its customers. In beginning to offer the credit card to its customers, the bank incurs costs for computer hardware and software, advertising, credit bureau reports, travel, educational and entertainment expenses, and temporary clerical services. The services, equipment, personnel, customers, and sales facilities are substantially similar. Under these circumstances, the bank would be expanding the existing trade or business rather than entering into a new separate trade or business.

i. A corporation provides investment banking services. The corporation acquires the assets of a partnership that underwrites and sells insurance. Investment banking and insurance services as well as other services such as merchant banking, and underwriting and selling securities are substantially similar or related financial services. ⁶ Under these circumstances, the corporation would be expanding the existing trade or business rather than entering into a new business.

D. Costs.

1. Introduction. Part II.D. describes the costs that must be capitalized with respect to an ACORN Transaction, which are (i) consideration paid in an ACORN Transaction, as described in Part II.D.2., and (ii) transaction costs of accomplishing or consummating an ACORN Transaction, as described in Part II.D.3.a. and b. Examples of costs that are not required to be capitalized under this Part II are set forth in Part II.D.3.c.

2. Consideration paid.

a. In general. Consideration paid in an ACORN Transaction includes the principal component of debt acquired or assumed in the transaction.

b. Examples.

1) Planning and establishing the organizational structure of a new entity. Taxpayer A establishes new corporation B and, in a section 351 transfer, transfers cash to B in exchange for the stock of the corporation. A's consideration paid is the cash contributed to B. B has no consideration paid in the transaction.

2) Raising capital and issuing debt, stock or other equity interests. Taxpayer C issues debt in exchange for cash. C has no consideration paid with respect to the transaction. The cash advanced to C by the lender as the principal of the debt is consideration paid.

3) Listing an entity's stock or other equity interests on a stock exchange. Taxpayer D lists its common stock on a stock exchange. D has no consideration paid in the transaction.

4) Reorganizing an entity's capital structure. Taxpayer E, an existing corporation, changes its capital structure under section 368(a)(1)(E). E has no consideration paid in the transaction.

5) Entering into a new trade or business by investigating and creating a new trade or business. Taxpayer F enters into a new trade or business by investigating and creating the new trade or business. F has no consideration paid in the transaction. ⁷

6) Acquiring the stock of a corporation conducting a trade or business, the ownership interest in a non-corporate entity conducting a trade or business, or assets of an existing trade or business in a taxable or non-taxable transaction. Taxpayer G acquires the stock of taxpayer H for cash in a taxable stock purchase. G's consideration paid in the ACORN Transaction is the cash paid to H's shareholders for the H stock acquired. H has no consideration paid in the transaction.

3. ACORN Transaction costs.

a. Transaction costs of accomplishing or consummating ACORN Transactions.

1) General rule. ACORN Transaction costs are costs of accomplishing or consummating an ACORN Transaction. See Examples in Part II.D.3.b. below.

2) Deductibility of certain recurring costs.

a) General and administrative costs. For principles providing for the deductibility of general and administrative costs that are costs of accomplishing or consummating an ACORN Transaction, see Part III.B.3.d.1) (relating to general and administrative costs paid or incurred in acquiring an asset).

b) Employee compensation costs. For principles providing for the deductibility of employee compensation costs that are costs of accomplishing or consummating an ACORN Transaction, see Part III.B.3.d.2) (relating to compensation costs paid or incurred in connection with the acquisition of an asset).

3) Allocation of costs among transactions and activities. For principles to be used in allocating a cost among transactions and activities, see Part III.B.3.c.

b. Examples of transaction costs required to be capitalized. The following are examples of costs of accomplishing or consummating an ACORN Transaction that must be capitalized:

1) Accounting and auditing costs. Accounting and auditing fees for services associated with (i) alteration of a corporation's capital structure, (ii) valuation of debt or equity issued, and (iii) registration of stock with the Securities and Exchange Commission. ⁸

2) Appraisal or valuation analysis and opinion fees. Appraisal or valuation analysis and opinion fees including costs of determining the price to be paid in the transaction. ⁹

3) Bond or debt issuance costs. ¹⁰ Bond or debt issuance costs incurred as a result of the consummation of the transaction.

4) Brokerage fees. Brokerage fees paid to brokers as a result of the consummation of the transaction. ¹¹

5) Commissions. Commissions paid to underwriters and agents for the seller or buyer as a result of the consummation of the transaction. ¹²

6) Commitment fees, standby charges, and loan origination fees. Commitment fees, standby charges and loan origination fees including fees paid to secure a financing commitment and to assure availability of funds when needed for the transaction. ¹³

7) Escrow costs. Escrow costs for escrow arrangements for the transaction. ¹⁴

8) Filing and registration fees. Filing and registration fees including fees for filings in connection with the transaction and for registration of debt or equity securities issued in the transaction. ¹⁵

9) Investigatory costs for new separate trades or businesses. Costs paid or incurred in searching for or investigating new separate trades or businesses including the costs of searching for or investigating an active trade or business for purposes of determining whether to enter a new separate trade or business and which new separate trade or business to enter. ¹⁶

a) Investigatory costs include costs paid or incurred to conduct industry research, to evaluate publicly available financial information, to analyze or survey potential markets, products, labor supply, transportation facilities, and preliminary due diligence that may include a review of financial projections or other internal documents. ¹⁷

b) A taxpayer may continue to pay or incur investigatory costs in an ACORN Transaction until the board of directors (or other person or group with actual authority to authorize participation in the transaction) of each party has approved the transaction and the parties have executed an agreement to enter into the transaction. ¹⁸

10) Investment banking costs. Investment banking costs for (i) providing advice and counsel related to the transaction if the cost of such advice and counsel is not an investigatory cost or otherwise deductible, (ii) negotiating and drafting the transaction agreement, (iii) valuations (including fees for valuations initially performed for purposes of defending a hostile takeover that have the effect of facilitating a subsequent merger), (iv) performing services related to rendering of a fairness opinion, and (v) executing and closing the transaction. ¹⁹

11) Legal costs. Legal costs for negotiating and drafting the documents necessary to accomplish or consummate the transaction including documents related to obtaining regulatory approvals, and title searches. ²⁰

12) Printing costs. Printing costs paid or incurred to reproduce documents related to the transaction. ²¹

13) Retainer Agreements. Retainer fees that are offset against the cost of legal or other fees of accomplishing or consummating the transaction. ²²

14) Shareholder solicitation costs. Shareholder solicitation costs including costs of preparing and mailing proxy solicitation materials for shareholder votes in connection with the transaction. ²³

15) Transfer agents' fees and expenses. Transfer agents' fees and expenses including costs and expenses paid or incurred in transferring debt or equity interests in the transaction.

16) Transfer taxes. Transfer taxes of a corporation including taxes paid or incurred by reason of a transfer of debt or equity securities or other assets in the transaction.

Many of the costs listed in the preceding paragraphs as examples of transaction costs that must be capitalized to the extent they are costs of accomplishing or consummating an ACORN Transaction also are start-up expenditures within the scope of section 195 and, thus, are eligible for sixty-month amortization under section 195. ²⁴

c. Examples of costs not required to be capitalized. The following are examples of costs that are not required to be capitalized under Part II:

1) Accounting and auditing costs. Accounting and auditing costs paid or incurred as part of the performance of general financial accounting, ongoing accounting functions, research and review of positions in connection with filing timely and accurate income tax returns, internal audit costs, and an annual audit that would have been performed even if no ACORN Transaction were under consideration. ²⁵

2) Advertising costs. ²⁶ Advertising costs.

3) Business integration costs. Business integration costs include management compensation, costs to retain key employees, integration of records and information systems. These costs also include costs of consolidating, eliminating, and integrating business equipment, locations, and operations.

4) Contract termination costs. Costs paid to terminate burdensome contracts. ²⁷

5) Employee change-in-control costs. Employee change-in-control costs including (i) payments to purchase or cancel employee stock options, warrants or similar rights, (ii) payments with respect to existing employment contracts, and (iii) payments to terminate non- qualified retirement plans. ²⁸

6) Employee severance costs. Employee severance costs for employees terminated in connection with an ACORN Transaction. ²⁹

7) General economic analysis and forecasting. General economic analysis and forecasting costs.

8) Insurance for directors and officers. Insurance for directors and officers. ³⁰

9) Interest costs. Interest costs.

10) Investigatory costs for business expansion. Costs paid or incurred in searching for or investigating an expansion of an active trade or business for purposes of determining whether to expand the business and which business (including the acquisition of stock of a corporation conducting a trade or business or the ownership interest in a non-corporate entity conducting a trade or business) or assets to acquire. ³¹

11) Investment banking costs. Investment banking costs to obtain general business or financial advice, assistance in strategic business planning, and to obtain investigatory services. ³²

12) Legal costs. Legal costs for services related to general corporate matters including services related to legal research and legal review of positions in connection with filing timely and accurate income tax returns, drafting and implementing employee stock option plans and other employee plans, strategic review of the market for merger and acquisition transactions, and retainer fees paid to the extent that services are not provided pursuant to the retainer fee or the services were not costs of accomplishing or consummating an ACORN Transaction. ³³

13) Ordinary costs. Part III.A.2. provides examples of ordinary costs.

14) Resistance costs.

a) Costs to resist a proposed ACORN Transaction if the costs did not facilitate accomplishing or consummating an ACORN Transaction. ³⁴

b) Example. A presented to T an unsolicited offer to purchase all of T's outstanding stock. T initially rejected A's offer, and A made a second unsolicited offer. Fearing a hostile takeover, T engaged an investment banking firm to prepare defensive measures, to consider alternative transactions, and to evaluate all proposals. The investment banking firm assisted T in implementing defensive tactics, negotiating a separate transaction with a white knight, and evaluating A's offers. After T rejected the second offer, A made a third offer that T found acceptable. T entered into an acquisition agreement with A and decided not to pursue the transaction with the white knight. T may deduct the costs of the abandoned white knight transaction and the costs of its initial resistance of A's offers to the extent that such costs did not facilitate the eventual transaction with A. T must capitalize the investment banking fees and other costs of accomplishing or consummating the transaction with A to the extent such investment banking fees would be capitalized as transaction costs under Part II. ³⁵

c) Example. B made payments pursuant to "white knight" agreements as a defensive measure against a hostile takeover attempt. Under these agreements, the "white knight" made a tender offer to acquire B's shares, and B agreed to pay the expenses of the "white knight's" tender offer as a "break-up" fee if the tender offer did not succeed. B's break-up fees are deductible under section 162(a). ³⁶

15) Shareholder, public, and industrial relations. Shareholder, public, and industrial relations.

16) Training costs. Training costs including costs for instructors and for routine updates of training materials. ³⁷

E. Recovery of capitalized costs.

1. In general. Capitalized costs of an ACORN Transaction are recovered through depreciation, amortization, or by an adjustment to basis at the time the property is used, sold or otherwise disposed of by the taxpayer.

a. Recovery of capitalized consideration paid. The applicable Internal Revenue Code and regulation provisions relating to the amortization, depreciation, and sale or disposition of property determine cost recovery of capitalized consideration paid in an ACORN Transaction.

b. Recovery of capitalized transaction costs.

1) Transaction costs capitalized in an ACORN Transaction that are recoverable under another provision of the Code such as section 195 (start-up expenditures) or section 248 (organization expenditures) are recovered under such provision.

2) Transaction costs capitalized in an ACORN Transaction that relate to issuing or reissuing debt are recoverable over the term of the debt as provided by existing law.

3) Other transaction costs capitalized in an ACORN Transactions are amortizable over a period of five years unless a taxpayer timely elects either (i) not to amortize such costs for a particular transaction or (ii) to amortize such costs for a particular transaction over a longer period.

2. Abandonment.

a. Costs paid or incurred to accomplish or consummate an ACORN Transaction may be deducted when the taxpayer abandons the ACORN Transaction.

b. Costs capitalized in an ACORN Transaction may be deducted as a result of abandonment of such transaction even if the transaction is an alternative to other, mutually exclusive transactions.

c. Abandonment of an ACORN Transaction may be evidenced by: (i) cessation of negotiations, (ii) introduction of an alternative suitor, or (iii) preliminary due diligence on another possible transaction.

d. For transactions in process at year-end, costs that would be required to be capitalized as costs of accomplishing or consummating an ACORN Transaction if the ACORN Transaction had been accomplished or consummated are capitalized, but such costs may be deductible in the following taxable year if the transaction is abandoned.

F. Method of accounting.

1. The treatment of an ACORN transaction cost as an amortizable transaction cost under II.D.3. above or a deductible cost and the recovery of any ACORN transaction cost under II.E.1.b. above constitute methods of accounting. ³⁸

2. Capitalization and expense methods for ACORN Transactions and amortization methods for transaction costs paid or incurred in ACORN Transactions are determined on a transaction-by-transaction basis.

III. Business Operations.

A. Ordinary costs.

1. General rule. Costs of operating, protecting, maintaining, improving or expanding an existing trade or business of the taxpayer are ordinary within the meaning of section 162 and not subject to the rules of section 263, except as provided above in Part II (ACORN Transactions) and below in Parts III.B (acquisition of assets), C (production of tangible assets), D (creation of separate and distinct intangible assets), E (defending or perfecting title to an asset), and in Part IV (repairs and capital improvements). ³⁹

2. Examples. Costs of operating, protecting, maintaining, improving or expanding a trade or business include costs paid or incurred ⁴⁰ in connection with the following activities:

a. Advertising or marketing the taxpayer's goods or services and promoting the taxpayer's trade or business without regard to the extent or objective of the advertising or marketing, including: efforts to keep the taxpayer's name before the public; institutional or goodwill advertising; creating or executing advertising campaigns; arranging for shelf space or slotting allowances; soliciting existing or prospective customers through direct mail or telemarketing; customer inducements; contests; selling expenses; market research; designing the physical construction of a product's package ("package design"); designing written information, styles of print, pictures or drawings, shapes, colors, spacing, and the like that make up the overall visual display of a product's package ("graphic design"); and advertising or promoting a new product prior to its introduction into the market. ⁴¹

b. Hiring, training, and relocating new employees or existing employees, including: transporting, housing, feeding and compensating instructors, interviewers, employees and potential employees during the process of hiring, training, or relocating. ⁴²

c. Improving or reengineering organizational processes, managerial processes, manufacturing processes, or service processes, including: training employees; moving equipment; hiring consultants; improving quality control; implementing just-in-time manufacturing; and obtaining certification by the International Organization for Standardization. ⁴³

d. Continuing a trade or business in a new way, including: introducing a new sales method for a product or service; introducing a new product or service to a line of products or services; and introducing a new medium for conducting a trade or business (e.g., the institution of electronic methods of doing business, including: the development of an Internet supply network with third parties, the implementation of internal networks and processes to interface with external networks, and the development of electronic communication systems and processes to link existing internal business systems to communicate effectively with existing or new customers via the Internet as well as enable general marketing and promotional activities in an electronic format). ⁴⁴

e. Developing a new sales territory or soliciting new customers. ⁴⁵

f. Retaining a sales territory or customers. ⁴⁶

g. Opening a new location, including: opening new retail stores, new restaurants, new manufacturing facilities, new distribution facilities, new storage facilities or new branch offices. ⁴⁷

h. Preserving or improving the reputation of a trade or business. ⁴⁸

i. Undertaking activities to operate more efficiently or reduce costs, including: severing employee relationships; terminating contracts; implementing energy conservation programs; upgrading technology; and integrating the previously distinct businesses of an acquirer and a target. ⁴⁹

j. Undertaking activities that principally relate to the taxpayer's past activities or business operations, including: severing employee relationships; terminating contracts; closing facilities; removing assets and waste (regardless of whether the removed asset is replaced with a new asset); and settling or defending lawsuits if the alleged wrongdoing was related to or part of taxpayer's business operations. ⁵⁰

k. Undertaking activities that principally relate to the current sale of the taxpayer's goods or services, including: offering incentives to customers who purchase the taxpayer's goods or services (e.g., rebates or free installation) and evaluating the customer's use of or need for the taxpayer's goods or services. ⁵¹

B. Costs of acquiring tangible or intangible assets.

1. Requirement of capitalization. A taxpayer must capitalize costs of acquiring an asset.

2. Definition of "asset." For this purpose, "asset" means any interest in real property or personal property (tangible or intangible) that (i) is either acquired for resale ⁵² or has an economic useful life in excess of twelve months ⁵³ and (ii) has an ascertainable and measurable value in money's worth in and of itself.

3. Definition of "costs of acquiring an asset."

a. In general. Costs of acquiring an asset are consideration paid for the asset (including the principal component of any debt acquired or assumed in connection with the acquisition) and transaction costs of accomplishing or consummating the acquisition. For this purpose, costs of placing an asset in service (e.g., transportation and installation costs) are treated as transaction costs of acquiring the asset.

b. Examples of transaction costs. The following are examples of transaction costs that must be capitalized if they are costs of accomplishing or consummating the acquisition of an asset:

1) Appraisal or valuation analysis and opinion fees for services to determine value. ⁵⁴

2) Brokerage fees. ⁵⁵

3) Commissions. ⁵⁶

4) Escrow costs. ⁵⁷

5) Filing and registration fees (e.g., for registration of debt or equity securities issued).

6) Investment banking costs (e.g., providing advice and counsel; negotiating and drafting agreements; or conducting valuations).

7) Legal fees for legal services (e.g., providing advice and counsel; negotiating and drafting documents; obtaining regulatory approvals; or conducting title searches).

8) Printing and other costs of reproducing documents. ⁵⁸

9) Transfer agents' fees and expenses.

10) Transfer taxes.

c. Allocation of transaction costs among capital transactions and non-capital transactions or activities.

1) In general. If transaction costs relate to accomplishing or consummating more than one transaction or activity, the taxpayer must make a reasonable allocation of the transaction costs between each capital transaction (i.e., an ACORN Transaction; acquiring a tangible or intangible asset; producing real property or tangible personal property; creating a separate and distinct intangible asset; or defending or perfecting title to a business or asset) and each non- capital transaction or activity to which the costs relate. Examples of reasonable allocations include (i) an allocation based on the time spent performing the transactions or activities, and (ii) an allocation based on the fees that would have been charged had services been contracted for separately.

2) Example of allocation of transaction costs. Taxpayer hired an accountant to analyze the financial impact of acquiring certain real property (task 1). Taxpayer also hired the accountant to perform ongoing accounting activities for taxpayer (e.g., internal cost audits and annual audits) (task 2). The accountant's fee must be reasonably allocated between task 1 and task 2. Acquiring an asset is a capital transaction, and thus, the fees properly allocable to task 1 must be capitalized into the cost of the real property. No portion of the fees allocable to task 2 must be capitalized. ⁵⁹

3) Example of reasonable allocation of transaction costs. After taxpayer decided to acquire three companies, taxpayer hired an investment banking firm to assist in the acquisitions. During the taxable year, taxpayer paid the investment banking firm $12 million for services relating to the transactions. The investment banking firm spent ten percent of its time on Transaction 1 (which was abandoned during the taxable year), thirty percent of its time on Transaction 2 (which was successfully completed during the taxable year), and sixty percent of its time on Transaction 3 (which was pursued through the end of the taxable year, but then abandoned in the next taxable year). An allocation of the firm's fee according to the time spent on each transaction (i.e., $1.2 million to Transaction 1; $3.6 million to Transaction 2, and $7.2 million to Transaction 3) is a reasonable allocation. Taxpayer may deduct the $1.2 million allocable to Transaction 1 in the taxable year. Taxpayer must capitalize the $3.6 million allocable to Transaction 2 and may recover that cost over 5 years. Taxpayer may deduct the $7.2 million allocable to Transaction 3 during the taxable year when Transaction 3 is abandoned.

d. Deductibility of certain recurring costs.

1) General and administrative costs. Taxpayers are not required to capitalize general and administrative costs. Examples of general and administrative costs include: (i) occupancy costs such as rent, depreciation, amortization, insurance, security, taxes, utilities, maintenance, and telephone, (ii) support costs such as secretarial costs and mail room costs, and (iii) costs for overall management or policy guidance functions.

2) Employee compensation costs.

a) In general. Taxpayers are not required to capitalize employee compensation costs (including costs of pension plans, other fringe benefits, and employee stock options). ⁶⁰

b) Examples of employee compensation costs.

i) Employee compensation. Employee X is paid an annual salary by taxpayer. Employee Y is paid an hourly wage. Employees X and Y spend all or substantially all of their time on activities related to the acquisition of assets. Taxpayer is not required to capitalize any portion of Employee X's or Employee Y's compensation.

ii) Employee bonus. During the tax year, taxpayer buys a new office building. At the end of the tax year, taxpayer pays a bonus to Employee Z, who played a critical role in accomplishing the acquisition. In a letter to Employee Z, taxpayer states that the bonus is in appreciation for Employee Z's hard work on the acquisition of the office building. Taxpayer may deduct the bonus.

3) De minimis costs. If a taxpayer has a written policy providing that any cost less than a specified minimum dollar amount will not be capitalized for tax purposes and for all significant non- tax purposes (e.g., financial, SEC, and regulatory reporting purposes), the taxpayer is not required to capitalize the costs described in that policy.

4) Selling expenses or other transaction costs paid or incurred in the taxpayer's routine income-producing activities.

a) In general. Taxpayers are not required to capitalize selling expenses or other transaction costs paid or incurred in the taxpayer's routine income-producing activities, including costs of soliciting and evaluating customers and costs of negotiating and evaluating contracts with customers. ⁶¹ For examples of this provision, see Part III.D.6 below.

b) Exceptions. The general rule in a) above regarding selling expenses or other transaction costs paid or incurred in the taxpayer's routine income-producing activities does not apply to:

i) Consideration paid or incurred for an asset (including the principal component of any debt acquired or assumed); and

ii) Costs otherwise required to be capitalized under Part II above (ACORN Transactions), Part IV below (repairs and capital improvements), or a provision of the Code other than section 263.

4. Cost recovery. Costs required to be capitalized pursuant to this Part III.B are included in the basis of the asset acquired and are recovered through depreciation, amortization, or by an adjustment to basis at the time the asset is used, sold, placed in service or otherwise disposed of by the taxpayer. Cost recovery is determined by the applicable Internal Revenue Code and regulation provisions relating to the amortization, depreciation, and sale or disposition of the asset.

5. Examples of costs of acquiring assets.

a. Building. Taxpayer purchased a building on leased land for $1,000,000 in cash and the assumption of $500,000 of debt. Prior to the purchase, taxpayer paid a real estate broker to locate the building, an appraiser to value the building, and a lawyer to negotiate and draft the purchase agreement. After the purchase, taxpayer paid a real estate transfer tax to State A. The cash paid to purchase the building and the adjusted issue price of the debt are costs of acquiring the building. The appraiser's fee, broker's fee, lawyer's fee and transfer taxes also are transaction costs of acquiring the building. Taxpayer is required to capitalize these costs and may recover the costs through depreciation of the building.

b. Redesign of manufacturing process. Taxpayer, in redesigning its manufacturing process to improve efficiency, hired a consultant, relocated machinery in its factory and purchased new machinery. The costs of the consultant and the costs of relocating existing machinery were paid or incurred by taxpayer in operating, protecting, maintaining, improving or expanding an existing trade or business and were ordinary expenses. The costs of acquiring new machinery (including freight and installation costs), even though paid or incurred in connection with operating, protecting, maintaining, improving or expanding an existing trade or business, are costs of acquiring an asset and must be capitalized and recovered through depreciation of the machinery.

c. Assets acquired in connection with advertising. Taxpayer engaged in an advertising campaign to sell a new product. In the campaign, taxpayer incurred costs to purchase billboards, to design advertising for the billboards, to place advertisements on the billboards, and to remove advertisements from the billboards. The costs of purchasing the billboards, even though paid or incurred in connection with operating, protecting, maintaining, improving or expanding an existing trade or business, are costs of acquiring an asset and must be capitalized. The remaining costs are advertising costs paid or incurred in operating, protecting, maintaining, improving or expanding a trade or business and are currently deductible. ⁶²

d. Computer software and hardware. (i) As part of an effort to improve taxpayer's business organizational processes, taxpayer converted its entire management software system to a new enterprise resource planning management software system. The software purchased by taxpayer integrated for the first time the workflow of business events and processes across all of taxpayer's business departments and functions. The software also linked taxpayer's business processes with those of customers and suppliers. Taxpayer paid or incurred the following costs: consulting fees both for advice directly relating to the software and for advice relating to the improvement and reengineering of taxpayer's business operations, costs of acquiring and installing the software, costs of separately acquiring computer hardware to be used with the new software, costs to modify the software to tailor it to taxpayer's business, and costs of training taxpayer's employees to use the new software.

(ii) The costs of the computer hardware are costs of acquiring an asset and must be capitalized and recovered under section 168. The costs of acquiring the software must be capitalized and amortized over 36 months under section 167(f). The costs to modify the software are currently deductible as costs of developing software. ⁶³ Likewise, the consulting costs relating to improving and reengineering taxpayer's business operations and the costs of training taxpayer's employees are currently deductible.

C. Costs of producing real property or tangible personal property. See section 263A and the regulations thereunder.

D. Costs of creating a separate and distinct intangible asset.

1. Requirement of capitalization. A taxpayer must capitalize costs of creating a separate and distinct intangible asset.

2. Definition of "separate and distinct intangible asset."

a. In general. A "separate and distinct intangible asset" is a distinct and recognizable intangible property interest that (i) has an economic useful life in excess of twelve months, (ii) has an ascertainable and measurable value in money or money's worth in and of itself, and (iii) commonly is acquired separately from a trade or business or could be so acquired if restrictions on assignability were ignored.

1) Examples of "separate and distinct intangible assets." The following, if possessing an economic useful life in excess of twelve months and an ascertainable and measurable value in money or money's worth in and of itself, are examples of separate and distinct intangible assets:

a) A copyright, franchise right, trademark, or trade name;

b) A lease agreement (including both the lessee's right to occupy or use real or tangible personal property and the lessor's right to receive payments for the occupation or use of real or tangible personal property); ⁶⁴

c) A license agreement (including both the licensee's right to use intangible property and the licensor's right to receive payments for the use of intangible property);

d) A loan agreement (including both the borrower's right to use money and the lender's right to receive payments for the use of money); ⁶⁵

e) A membership; ⁶⁶

f) A covenant not to compete; ⁶⁷

g) The right to conduct a specified type of business (for example, a business license granted by a governmental agency or a state bar certification); ⁶⁸

h) An exclusive right to operate in a specified geographic area; ⁶⁹ and

i) Certain rights to sell goods and services, and certain rights to buy goods and services as provided below.

2) Effect of renewability of a right. For this purpose, the economic useful life of a right that exists pursuant to a contract or of a right granted by a governmental unit includes any renewal period, if, based on all of the facts and circumstances in existence at any time during the taxable year in which the right is created, the facts clearly indicate a substantial likelihood of renewal. The following types of provisions are not taken into account in determining the economic useful life of a right: a right to renew on the same terms as are available to others, and a right to renew in a competitive auction or similar process that is designed to reflect fair market value and in which the taxpayer is not contractually advantaged. ⁷⁰

b. Goodwill. For this purpose, goodwill is not a separate and distinct intangible asset. Goodwill is the value of a trade or business attributable to the expectancy of continued customer patronage, due to the name or reputation of a trade or business or any other factor. ⁷¹

c. Going concern value. For this purpose, going concern value is not a separate and distinct intangible asset. Going concern value is the additional value that attaches to property by reason of its existence as an integral part of an ongoing business activity. Going concern value includes the value attributable to the ability of a trade or business (or a part of a trade or business) to continue functioning or generating income without interruption notwithstanding a change in ownership. ⁷²

d. Work-force-in-place. For this purpose, work-force-in-place (sometimes referred to as agency force or assembled workforce) is not a separate and distinct intangible asset. Work-force-in-place is the composition of a work force (for example, the experience, education, or training of a workforce), the terms and conditions of employment, and any other value placed on employees or any of their attributes. Work-force-in-place does not include any covenant not to compete or other similar arrangement. ⁷³

e. Information base. For this purpose, an information base is not a separate and distinct intangible asset. An information base includes business books and records, operating systems, a customer- related information base (i.e., any information base that includes lists or other information with respect to current or prospective customers), and any other information base, regardless of the method of recording the information, including for example, the intangible value of technical manuals, training manuals, or programs, data files, and accounting or inventory control systems. Other examples include customer lists, subscription lists, insurance expiration, patient or client files, or lists of newspaper, magazine, radio, or television advertisers. ⁷⁴

f. Formulas, processes, patterns, know-how, format, graphic design, or package design. For this purpose, a formula, process, pattern, know-how, format, graphic design, or package design is not a separate and distinct intangible asset. ⁷⁵

g. Customer-based intangibles.

1) In general. For this purpose, a customer-based intangible is not a separate and distinct intangible asset, except as provided in 2) below. A customer-based intangible is any composition of market, market share, or other value resulting from the future provision of goods or services pursuant to contractual or other relationships in the ordinary course of business with customers. Examples include a customer base, a circulation base, an undeveloped market or market growth, insurance in force, a qualification to supply goods or services to a particular customer or other relationship with customers involving the future provision of goods or services. A customer-based intangible also includes the deposit base, checking accounts, savings accounts, escrow accounts, and other similar items of a financial institution. ⁷⁶

2) Exception for certain rights to sell goods or services. A taxpayer's right to sell goods or services to a customer is treated as a separate and distinct intangible asset if: (i) the taxpayer has the right to sell to the customer a fixed or minimum amount of goods or services for a fixed price or a price determined by a formula, (ii) the taxpayer's right to sell the goods or services has an economic useful life in excess of 12 months (ignoring rights of renewability), and (iii) the customer cannot terminate the taxpayer's right within 12 months of its creation without incurring a significant cost, the payment of which is pursuant to the terms of the contract and is commonly enforced by the taxpayer. See, however, Part III.D.3.d.4) for principles that provide for the deductibility of selling expenses or other transaction costs paid or incurred in the taxpayer's routine income-producing activities.

h. Supplier-based intangibles.

1) In general. For this purpose, a supplier-based intangible is not a separate and distinct intangible asset, except as provided in 2) below. A supplier-based intangible is the value resulting from the future acquisition, pursuant to contractual or other relationships with suppliers in the ordinary course of business, of goods or services that will be sold or used by the taxpayer. The following are examples of supplier-based intangibles: a favorable relationship with persons providing distribution services (such as favorable shelf or display space at a retail outlet), or a favorable credit rating. ⁷⁷

2) Exception for certain rights to buy goods or services. A taxpayer's right to buy goods or services from a supplier is treated as a separate and distinct intangible asset if: (i) the taxpayer has the right to buy from the supplier a fixed or minimum amount of goods or services (or an amount to be determined solely by the taxpayer) for a fixed price or a price determined by a formula, (ii) the taxpayer's right to buy the goods or services has an economic useful life in excess of 12 months (ignoring rights of renewability), and (iii) the supplier cannot terminate the taxpayer's right within 12 months of its creation without incurring a significant cost, the payment of which is pursuant to the terms of the contract and is commonly enforced by the taxpayer.

i. Examples of activities or costs that do not create a separate and distinct intangible asset.

1) Information base. Taxpayer conducted a survey to develop a list of potential customers. Taxpayer's development of the customer list is not the creation of a separate and distinct intangible asset.

2) Customer-based intangible - Extensive campaign to get new customers. Taxpayer, a natural gas company, initially had no business in City A. Taxpayer engaged in an extensive campaign to get customers in City A. As part of that campaign, taxpayer paid contractors to install gas appliances in customers' homes, subsidized the installation of gas appliances, and paid contactors to perform energy efficiency audits. Taxpayer's campaign was so successful that it drove its only competitor into bankruptcy. The fact that taxpayer was the only gas utility in City A essentially assured that taxpayer would receive revenue from the sale of gas for many years. The costs of the campaign were costs of operating, protecting, maintaining, improving or expanding taxpayer's business. The costs did not result in the acquisition of assets, the production of tangible assets, the creation of separate and distinct intangible assets, or the defense or perfection of title to assets. Thus, notwithstanding that the campaign increased taxpayer's customer base and the value of taxpayer's business by creating or enhancing goodwill or similar intangibles of the business, the costs of the campaign are not required to be capitalized. ⁷⁸

3) Customer-based intangible - Service contracts. Taxpayer, a provider of telecommunication services, regularly solicits and signs customers to service contracts in excess of one year. There is no significant penalty imposed on the customers for early termination under the terms of the contract that is commonly enforced by taxpayer. Taxpayer does not create separate and distinct intangible assets when it enters into new service contracts with its customers. Accordingly, taxpayer is not required to capitalize commissions paid to third parties and employees who solicit new customer contracts or inducements provided to new customers who enter into service contracts with taxpayer.

4) Customer-based intangible - Inducements to customers. In order to induce a major, new customer to purchase taxpayer's product, taxpayer issued warrants to the customer. Although taxpayer hoped the issuance of the warrants would result in a long-term relationship with that customer, the customer was free to purchase goods from any party, and taxpayer did not have a right to sell more of its goods to the customer. Taxpayer did not create a separate and distinct intangible asset when it offered warrants to the new customer. ⁷⁹

5) Customer-based intangible - Subscription contest. Taxpayer owned and published a daily newspaper. Taxpayer conducted a one-year subscription contest as a promotion to get new customers. Taxpayer incurred costs for professional managers and solicitors and for prizes. The contest was successful and substantially increased the newspaper's circulation. The new customers could terminate their subscriptions at any time without incurring substantial costs. The costs incurred by taxpayer did not result in the creation of a separate and distinct assets, and thus, the costs are deductible. ⁸⁰

6) Customer-based intangible - New distribution program. Taxpayer, a candy manufacturer, had historically sold its candy only in urban areas. Taxpayer incurred costs to develop a major new distribution market for wholesale customers in suburban areas. Taxpayer entered into five-year contracts with store owners under which taxpayer agreed to sell its candy at a discount. Although the store owners agreed to use reasonable efforts to sell taxpayer's candy, the store owners did not agree to buy or sell any minimum amount of candy, nor did they guarantee any amount of sales. Although taxpayer hoped the new distribution market would produce significant revenue for several years, the store owners were not obligated to buy a fixed or minimum amount of candy. The costs were incurred by taxpayer in operating, protecting, maintaining, improving or expanding taxpayer's existing trade or business, and thus, the costs are not required to be capitalized. ⁸¹

7) Redesign of manufacturing process. In the year 2001, taxpayer engaged in a redesign of its manufacturing process to improve efficiency. Taxpayer had undertaken process redesign in prior years as part of the continuous improvement of its business operations. Taxpayer's redesign projects varied from year to year in both size and objectives, sometimes taxpayer converted from batch to "just-in- time" and sometimes taxpayer simply redesigned its process without changing from batch to "just-in-time." Based on projections, taxpayer hoped and expected that the redesign would result in future cost savings and allow additional production capacity in the same space or otherwise improve the efficiency of the manufacturing process. During the 2001 redesign, taxpayer incurred costs in (i) reconfiguring manufacturing facilities by moving machinery and equipment to different locations within the same facility, (ii) acquiring some new machines and equipment, (iii) acquiring materials and supplies used in the redesign process, (iv) reducing the size of its workforce, (v) training employees in the new process, and (vi) obtaining a consultant's help in the redesign. The costs to acquire new machinery are costs of acquiring assets and must be capitalized. These costs can be recovered in depreciating the machinery. The remaining costs of the 2001 redesign project (i.e., the relocation costs, supplies, workforce reduction, training and consulting fees) are incurred in operating, protecting, maintaining, improving or expanding taxpayer's existing trade or business, and thus, are deductible. ⁸²

8) Contract termination. Taxpayer, a candy manufacturer, had entered into long-term contracts with wholesale customers throughout the country, under which taxpayer agreed to sell candy at a discount. The store owners did not agree to buy or sell any minimum amount of candy, nor did they guarantee any amount of sales. At times, if a contract became economically unfavorable to taxpayer, taxpayer would negotiate for its termination. In a major undertaking, taxpayer decided to reevaluate all of its contractual arrangements with wholesalers and to terminate all of the arrangements that were economically unfavorable to taxpayer. As a result of this undertaking, taxpayer terminated its contractual arrangements with a large number of its wholesale customers and, in certain cases, entered into arrangements with new wholesale customers on similar contractual terms. The contract termination costs are incurred in operating, protecting, maintaining, improving or expanding taxpayer's existing trade or business and do not result in the creation of a separate and distinct intangible asset. Thus, the costs are currently deductible.

9) Variable annuity contracts. Taxpayer, a life insurance company, incurred costs to register certain variable annuity contracts with the Securities and Exchange Commission and state insurance departments. To ensure that it has desirable contracts to sell, taxpayer continually makes changes in the portfolio of products by changing existing policies, developing new policies, and terminating outdated policies. Taxpayer analyzes each new product to determine whether the product could be marketed on a profitable basis over a long-term period. Although insurance companies are required to register new products, there is no prohibition of one insurance company duplicating the product of another company. The costs incurred by taxpayer to register the annuity contracts do not create a separate and distinct intangible asset, and thus, the costs are ordinary and not required to be capitalized. ⁸³

10) Costs relating to past activities. Taxpayer is engaged in the business of underwriting the public sale of stock offerings and purchasing securities for resale to customers. Taxpayer was brought to trial upon charges of violating the fraud section of the Securities Act of 1933 and the mail fraud statute, and with conspiring to violate those statutes. Taxpayer incurred legal expenses in the unsuccessful defense of its criminal prosecution. The legal expenses principally relate to taxpayer's past activities or business operations (i.e., are described in Part III.A.2.j.). The costs do not create a separate and distinct intangible asset, and thus, the costs are deductible. ⁸⁴

11) Supplier-based intangible. Taxpayer made payments to suppliers to encourage them to sell their products or services to Taxpayer. Taxpayer obtained no enforceable right to buy goods or services from the suppliers and the suppliers could stop selling to taxpayer at any time. Thus, Taxpayer did not create a separate and distinct intangible asset. ⁸⁵ See, however, section 263A.

j. Prepaid expenses.

1) Treatment as a separate and distinct intangible asset. An expense that is prepaid for more than twelve months is treated as a separate and distinct intangible asset. ⁸⁶ The fact that such a prepayment is treated as a separate and distinct intangible asset does not imply that a taxpayer who, for example, makes such a prepayment would treat the amount prepaid as anything other than a payment for goods or services when the prepayment is applied toward the price of the goods or services. ⁸⁷

2) Examples.

a) Prepaid insurance. (i) Taxpayer prepays $90,000 for a three- year insurance contract. If the contract is terminated before the end of three years, the insurer is require to reimburse taxpayer for a proportionate share of the prepayment (e.g., if the contract terminates after 2 years, the insurer would have to return $30,000 of the prepaid amount). (ii) Under the principles of section 461, taxpayer's liability for the insurance is incurred upon payment. The $90,000 prepayment is required to be capitalized under section 263, and may be recovered ratably over three years.

b) Prepaid services. (i) Taxpayer prepays $90,000 for a three- year advertising contract. If the advertiser stops providing advertising services before the end of three years, the advertiser is require to reimburse taxpayer for a proportionate share of the prepayment (e.g., if the contract terminates after 2 years, the advertiser would have to return $30,000 of the prepaid amount). (ii) Under the principles of section 461, economic performance occurs with respect to the advertising service liability as the services are performed over the three years. Taxpayer may deduct $30,000 for the advertising services each year for three years as economic performance occurs. Section 263 does not apply to require capitalization of the prepayment. See Part I.B.4 (relating to "otherwise deductible" costs).

3. Definition of "costs of creating a separate and distinct intangible asset."

a. In general. Costs of creating a separate and distinct intangible asset are consideration paid (including the principal component of any debt acquired or assumed) and transaction costs of accomplishing or consummating the creation. Costs of creating an intangible asset such as a copyright or trademark do not include the costs of creating the underlying intangible.

b. Costs that do not create a separate and distinct intangible asset. Costs are not costs of creating a separate and distinct intangible asset if the costs: (i) are paid as part of a series of payments, (ii) are payable not less frequently than annually throughout the economic useful life of the intangible asset, and (iii) are substantially equal in amount, are based on the benefit received by the taxpayer from the intangible asset during the payment period (e.g., payments are based on a percentage of annual gross receipts from the taxpayer's usage of the intangible asset) or are based on principles of economic accrual. Examples include: interest paid on a loan, rent paid for the use of property, and royalties paid for the use of intangible property. P

c. Examples of transaction costs. For examples of transaction costs that must be capitalized if they are costs of accomplishing or consummating the creation of a separate and distinct intangible asset, see the costs listed in Part III.B.3.b above (similar costs arising in connection with the acquisition of an asset). Other examples include commitment fees, standby charges and loan origination fees paid to secure a financing commitment and assure availability of funds. ⁸⁸

d. Deductibility of certain recurring costs.

1) General and administrative costs. For principles providing for the deductibility of general and administrative costs that are costs of accomplishing or consummating the creation of a separate and distinct intangible asset, see Part III.B.3.d.1).

2) Employee compensation costs. For principles providing for the deductibility of employee compensation costs that are costs of accomplishing or consummating the creation of a separate and distinct intangible asset, see Part III.B.3.d.2).

3) De minimis costs. For principles providing for the deductibility of de minimis costs of accomplishing or consummating the creation of a separate and distinct intangible asset, see Part III.B.3.d.3).

4) Selling expenses or other transaction costs paid or incurred in the taxpayer's routine income-producing activities. For principles providing for the deductibility of selling expenses or other transaction costs paid or incurred in the taxpayer's routine income- producing activities, including costs of soliciting and evaluating customers and costs of negotiating and evaluating contracts with customers, see Part III.B.3.d.4). For examples of this provision, see Part III.D.6 below.

4. Cost recovery of capitalized costs of creating a separate and distinct intangible asset.

a. In general. Except as provided below, costs required to be capitalized pursuant to this Part III.D are amortized ratably over the economic useful life of the intangible asset. Unamortized costs are recovered at the time the intangible asset is sold, abandoned, or otherwise disposed of by the taxpayer.

b. Economic useful life of a contract or right granted by a governmental unit. For this purpose, except as provided in c. below, the economic useful life of an intangible asset that arises pursuant to a contract or of a right granted by a governmental unit is determined in accordance with the rules set forth in Part III.D.2.a.2) (regarding renewability).

c. Amortization principles for rights to buy or sell a fixed amount of goods or services. Costs of creating a right to buy or sell a fixed amount of goods or services are amortized for each taxable year by multiplying the cost of the right by a fraction, the numerator of which is the amount of goods or services bought or sold during the taxable year and the denominator of which is the total amount of goods or services to be bought or sold under the terms of the contract. ⁸⁹ Under no circumstances will the economic useful life of an intangible asset described in Part III.D.2.g.2) or h.2) above (relating to certain rights to buy or sell goods or services) be treated as exceeding fifteen years. ⁹⁰

5. Examples of costs that create a separate and distinct intangible asset.

a. Debt. Taxpayer purchased equipment for $100,000. Taxpayer paid $10,000 in cash and incurred $90,000 of indebtedness to provide the remaining consideration for the equipment. Taxpayer is required to capitalize the $100,000 cost of the equipment and may recover such costs through depreciation of the equipment. In addition, taxpayer created a separate and distinct intangible asset - the loan. Taxpayer must capitalize the costs of creating the loan (e.g., commitment fees) and may recover the costs through amortization over the term of the loan. ⁹¹

b. Lease of real property. On January 1, 2001, taxpayer/lessee entered into a one-year lease of a building, providing for an annual rental payment of $20,000. Taxpayer paid a $10,000 finder's fee to the real estate broker who located the building and an up-front amount to the lessor to induce the lessor to enter into the lease. Taxpayer could renew the original terms of the lease annually for up to nine additional years. Because of the very favorable lease terms to taxpayer, both parties reasonably expected that taxpayer would renew the lease each year. Taxpayer created a separate and distinct intangible asset - the lease. Taxpayer must capitalize the finder's fee and the up-front amount paid to the lessor and may recover the costs ratably over ten years. Taxpayer may deduct the annual rental payment of $20,000. To the extent that lessor provides any services to taxpayer under the lease (e.g., security, basic maintenance, or garbage collection), the costs of such services are not costs of creating the lease and may be deducted as the costs are incurred under the principles of economic performance in section 461.

c. Lease of personal property. (1) Taxpayer/lessee leased computers from a lessor under a seven-year contract. At the end of the fourth year, the parties renegotiated the contract terms for the remaining three years. Taxpayer created a separate and distinct intangible asset -- the lease -- when it initially entered into the lease and when the lease was renegotiated. ⁹² The legal fees paid by taxpayer to negotiate the lease must be capitalized and may be recovered ratably over seven years (i.e., the term of the initial lease). The legal fees paid by taxpayer to renegotiate the lease must be capitalized and may be recovered ratably over three years (i.e., the term of the renegotiated lease). Taxpayer may deduct its monthly rental costs.

(2) Same as (1), except that, at the end of the fourth year, the parties negotiated for the cancellation of the lease. Upon contract termination, taxpayer may recover any legal fees that were paid when the lease was initially created and that had not been recovered. Any legal fees paid by taxpayer in negotiating the cancellation of the lease are costs of operating, protecting, maintaining, improving or expanding an existing trade or business and are deductible.

d. Lease of personal property. Taxpayer/lessor is in the business of leasing equipment. Taxpayer incurred transaction costs when it leased computers to a lessee under a three-year lease. Taxpayer created a separate and distinct intangible asset when it entered into the lease. See, however, Part III.D.3.d. for principles that provide for the deductibility of selling expenses or other transaction costs paid or incurred in the taxpayer's routine income- producing activities. ⁹³

e. Customer-based intangible / Supplier-based intangible. (1) Buyer entered into a three-year contract with Supplier 1 that obligated Buyer to purchase 100 widgets per year at a fixed price from Supplier 1. Under the terms of the contract, neither party could terminate the contract without incurring a substantial fee. Because Buyer acquired the right to purchase a minimum number of widgets at a fixed price, Buyer created a separate and distinct intangible asset (i.e., the contractual right to purchase the widgets at a fixed price) and must capitalize and amortize costs to create the contract over three years in accordance with Part III.D.4.c. Because Supplier 1 acquired the right to sell a minimum number of widgets per year to Buyer at a fixed price, Supplier 1 also created a separate and distinct intangible asset. See, however, Part III.D.3.d. for principles that provide for the deductibility of selling expenses or other transaction costs paid or incurred in the taxpayer's routine income-producing activities.

(2) Same as (1), except Buyer could terminate the contract at any time for a minimal fee. Supplier 1 did not create a separate and distinct intangible asset when it entered into the contract with Buyer. Accordingly, Supplier 1 is not required to capitalize any costs incurred in entering into the contract with Buyer. Buyer is treated the same as in (1) above.

f. Customer-based intangible / Supplier-based intangible. Buyer entered into a four-year contract with Supplier 2 that gave Buyer the right to purchase all the widgets it could use from Supplier 2 at market price. Under the terms of the contract, neither party could terminate the contract without incurring a substantial fee. Buyer created a separate and distinct intangible asset (i.e., the contractual right to purchase at market price an amount of widgets to be determined solely by Buyer). Buyer must capitalize costs of creating that asset and amortize those costs over four years in accordance with Part III.D.3. and 4. Because Buyer was not obligated to purchase any widgets under the contract, Supplier 2 did not create a separate and distinct intangible asset.

g. Covenant not to compete. Taxpayer made an up-front payment to a former employee for a six-year covenant not to compete. The covenant was not created in connection with an acquisition of a trade or business. Taxpayer also made equal annual payments to the former employee over the term of the covenant. Taxpayer's up-front payment is a cost of creating a separate and distinct intangible asset (i.e., the covenant not to compete) and must be capitalized. Taxpayer may recover the up-front payment ratably over the six-year term of the covenant. Taxpayer's annual payments to the former employee are not costs of creating a separate and distinct intangible asset and may be deducted currently.

6. Examples of selling expenses and other transaction costs paid or incurred in the taxpayer's routine income-producing activities.

a. Bidding costs or commissions paid by a taxpayer in the business of selling goods or services to obtain sales contracts. Taxpayer is engaged in the business of providing cleaning services. Taxpayer enters into an agreement to be the exclusive supplier of cleaning services to Company A for five years. Neither party can terminate the agreement without incurring a significant cost pursuant to the terms of the agreement. Any amount paid by taxpayer to Company A to induce Company A to enter into the agreement is consideration paid for the creation of a separate and distinct intangible asset (the contractual right to be compensated at a fixed price for providing cleaning services) and must be capitalized. However, taxpayer may deduct transaction costs paid or incurred in bidding for that agreement (including commission costs) because those costs are selling expenses or other transaction costs paid or incurred in taxpayer's routine income-producing activities. ⁹⁴

b. Loan origination or loan acquisition costs paid or incurred by a taxpayer in the business of lending money or financing. Taxpayer is in the business of lending money. Taxpayer lends money to borrowers for more than twelve months. Although taxpayer must capitalize the amounts loaned to the borrower (i.e., the loan proceeds that result in the loan receivable), taxpayer may deduct transaction costs incurred in determining whether to approve the loan (e.g., credit screening, property reports, appraisals, recording of security interests, and commissions paid to third parties or employees), because these costs are transaction costs paid or incurred in the routine income-producing activities (lending money) of the taxpayer's business operations. ⁹⁵ Similarly, a taxpayer in the business of financing may deduct similar transaction costs incurred in connection with the acquisition of an existing loan.

E. Costs of defending or perfecting title to an asset.

1. Requirement of capitalization. A taxpayer must capitalize the costs of defending or perfecting title to an asset, and such costs are treated as costs of acquiring the asset.

2. Definition of "costs of defending or perfecting title to an asset." Costs of defending or perfecting title to an asset include consideration paid (including the principal component of any debt acquired or assumed in connection with the defense or perfection) and transaction costs of accomplishing or consummating the defense or perfection.

3. Deductibility of certain recurring costs.

a. General and administrative costs. For principles providing for the deductibility of general and administrative costs that are costs of accomplishing or consummating the defense or perfection of title to an asset, see Part III.B.3.d.1).

b. Employee compensation costs. For principles providing for the deductibility of employee compensation costs that are costs of accomplishing or consummating the defense or perfection of title to an asset, see Part III.B.3.d.2).

c. De minimis costs. For principles providing for the deductibility of de minimis costs of accomplishing or consummating the defense or perfection of title to an asset, see Part III.B.3.d.3).

4. Example of costs of defending title to an asset. In the year 2000, taxpayer purchases an office building on leased land. In 2005, taxpayer's title to the building is challenged by a former owner. Taxpayer hires a law firm to defend its title to the building. The law firm, with assistance from certain of taxpayer's employees, negotiates a settlement. Pursuant to the settlement agreement, taxpayer makes a payment to the prior owner for a release of all claims. Any compensation costs paid to taxpayer's employees who performed services in connection with the defense of title are deductible. The legal fees and settlements costs are treated as costs of acquiring a building and are recovered under section 168.

IV. Repairs and Capital Improvements.

A. General rules.

1. Overview. This part concerns expenditures to repair, maintain, rehabilitate, or improve assets. Expenditures that qualify as repairs are deductible in the tax year in which paid or incurred. If a taxpayer elects the Modified Repair Allowance System (MRAS), the treatment of expenditures is determined under MRAS set forth below in Part IV.B. If a taxpayer does not elect MRAS or MRAS does not apply to an expenditure (see Part IV.B.4. below), the treatment of the expenditure is determined under the rules for Other Expenditures set forth below in Part IV.C. With certain exceptions and safe harbors, Part IV.C. requires capitalization if the expenditure (1) materially increases the value of an asset, (2) materially extends the useful life of an asset, or (3) modifies an asset and makes it suitable for a new or substantially different use. Unless explicitly provided to the contrary, all other expenditures to repair, maintain, rehabilitate, or improve assets are currently deductible repair expenditures.

2. De minimis costs. If a taxpayer has a written policy providing that any cost in an amount less than a specified minimum dollar amount (or a minimum percentage of replacement cost) for repair, maintenance, rehabilitation or improvement of an asset is not required to be capitalized for tax purposes and all significant non- tax purposes (e.g., financial, SEC, and regulatory reporting), then the taxpayer is not required to capitalize the costs described in that policy.

B. MRAS. ⁹⁶

1. General rule. If the taxpayer elects MRAS, expenditures for repair, maintenance, rehabilitation or improvement of assets that are not Significant Capital Improvements are currently deductible up to the Repair Allowance for the tax year as defined in Part IV.B.6. Significant Capital Improvements and expenditures in excess of the Repair Allowance are capitalized.

2. MRAS election.

a. Election procedure. A taxpayer may elect to use the MRAS for any tax year. The election is made on a timely filed tax return (including extensions) for the year for which the election is made.

b. Scope of election. If elected, MRAS applies for the year of election to all Applicable Repair Expenditures with respect to (i) all depreciable personal property then in service, (ii) all personal property leased to the taxpayer, and (iii) real property included in a class assigned a repair allowance under Rev. Proc. 83-35, 1983-1 C.B. 745 (or a successor pronouncement).

c. Applicable Repair Expenditures. Applicable Repair Expenditures are expenditures for repair, maintenance, rehabilitation or improvement of assets, other than those that are Significant Capital Improvements under Part IV.B.7. ⁹⁷

3. Repair Allowance Percentage.

a. General rule. The Repair Allowance for any class of property is based on the percentage applicable for that class. If MRAS is elected for any year, the Repair Allowance applies to all property then in service without regard to the length of its depreciation recovery period (i.e., the Repair Allowance applies to property still in service even after the end of the property's depreciation recovery period).

b. Option 1. The Repair Allowance is the percentage provided in Rev. Proc. 83-35 (or a successor pronouncement) for the ADR classes for which an allowance is provided. For assets in ADR classes for which no allowance is provided, and for assets not included in any ADR class within Rev. Proc. 83-35 (or a successor pronouncement), the percentages in TABLE A apply for each MACRS class:

                               TABLE A

4. Basis of property to which the Repair Allowance Percentage is applied.

a. The Repair Allowance Percentage for a MACRS or ADR class is applied to the average unadjusted basis of property in that class for the tax year (computed by adding the bases at the beginning and end of the year and dividing by two). Any new capitalized amount resulting from an expenditure that is a Significant Capital Improvement is included in the end of year basis for the year of such expenditure. Any new capitalized amount resulting from Applicable Repair Expenditures in excess of the Repair Allowance is not included in determining the end of year basis for the year of such excess. The new capitalized amount resulting from excess Applicable Repair Expenditures is included in the asset base for the following number of years equal to its recovery period. Property in a MACRS or ADR class includes property that would be in that class if MACRS or ADR applied to such property. This includes property placed in service before the effective date of MACRS; property to which MACRS does not otherwise apply; property with respect to which the taxpayer properly elected out of MACRS; and property leased to the taxpayer.

b. The unadjusted basis of an asset used to compute the Repair Allowance for a MACRS or ADR class is the taxpayer's original unadjusted basis of the asset determined under section 1012 or other applicable provisions. ⁹⁸ Except with respect to the capitalized cost of the excess Applicable Repair Expenditure (see Part IV.B.4.a. above), the unadjusted basis of an asset is used in determining the Repair Allowance as long as the asset is in service, even if the MACRS recovery period for the asset has terminated.

c. To the extent basis for depreciation purposes is determined under a step-into-the-shoes rule (e.g., following a section 351 transaction) (see section 168(i)(7) and Notice 2000-4, 2000-3 I.R.B. 313), the unadjusted basis is the transferor's original unadjusted basis.

d. For leased property, the basis included is the original cost basis of the lessor, if known by the taxpayer, or, if not, the fair market value of the property at the inception of the lease to the taxpayer (e.g., based on the rental payments provided in the lease). ⁹⁹ The basis of leased property is not included in basis for MRAS purposes after the lease ends.

5. Completely excluded expenditures. The following are excluded from MRAS:

a. Amounts deductible under section 165 regarding casualty losses;

b. Expenditures to remedy hazardous conditions described in Part IV.D.2.d.; ¹⁰⁰ and

c. Expenditures to dismantle, demolish, or remove an asset in the process of retirement; which, in such case, are treated as a deductible expense. ¹⁰¹

6. Determination of Repair Allowance.

a. The Repair Allowance for each class is determined by multiplying the average unadjusted basis of property in that class by the Repair Allowance Percentage for that class.

b. Example:

1) A taxpayer with $1,000x of unadjusted basis of five-year assets at the beginning of the tax year and $1,200x of unadjusted basis of five-year assets at the end of the tax year would have a Repair Allowance for five-year property for that tax year under Option 2 equal to $165x. ($1,000x + $1,200x = $2,200x, divided by 2 = $1,100x, times 15% = $165x.)

2) If, during the tax year, the taxpayer has $200x of Applicable Repair Expenditures relating to five-year property, the taxpayer would be allowed to deduct $165x of those expenditures as repairs, and would be required to capitalize $35x as a new five-year MACRS asset placed in service during that tax year. The $35x would be included in basis for purposes of computing the MRAS Repair Allowance as of the beginning of the following year.

7. Significant Capital Improvements. ¹⁰²

a. Treatment of Significant Capital Improvements. Expenditures for Significant Capital Improvements are chargeable to a capital account in the year paid or incurred.

b. Significant Capital Improvements. Subject to the operating rule in Part IV.B.7.c., below, the following are expenditures for Significant Capital Improvements:

1) An expenditure that increases by twenty-five percent or more the productivity of an asset as compared with its productivity when the asset was first placed in service by the taxpayer.

2) An expenditure that increases by twenty-five percent or more the capacity of an asset as compared with its capacity when the asset was first placed in service by the taxpayer.

3) An expenditure that modifies an asset and makes it suitable for a new or substantially different use.

a) An expenditure does not adapt an asset to a new or substantially different use merely because, immediately before or after the expenditure, the taxpayer holds the asset in an idle state. ¹⁰³

b) An expenditure does not adapt an asset to a new or substantially different use merely because, immediately after the expenditure, the taxpayer sells or otherwise disposes of the asset. ¹⁰⁴

c) Example. The taxpayer, a manufacturer of paper products, incurred expenditures to remediate soil and groundwater that had been contaminated by hazardous waste in connection with the operation of one of the taxpayer's pulp and paper mills. The expenditures were incurred in connection with closing the mill and, immediately following the remediation activity, the property was held in an idle state for several years. The taxpayer's soil and groundwater remediation expenditures are not considered to have adapted the property to a new or substantially different use.

4) An expenditure that results in the acquisition of an asset, as defined in Part III.B.2.

5) An expenditure for replacement of a part in or component or portion of an asset if the part, component, or portion replaced was retired in a retirement for which gain or loss (i) is recognized by the taxpayer, (ii) would be recognized by the taxpayer but for a special non-recognition provision of the Code or section 1.1502-13 of the regulations, or (iii) is not recognized because the adjusted basis of the asset is zero.

6) In the case of a building or other structure (in addition to the foregoing), an expenditure for additional cubic or linear space.

c. Operating rule. Expenditures that increase the productivity or capacity of an asset are not treated as expenditures for Significant Capital Improvements under Part IV.B.7.b.1) or 2) if the increase in productivity or capacity is incidental to replacement of malfunctioning or worn parts or components in a cost-effective manner. For example, expenditures to replace a worn board in a computer with a new board that has enhanced capabilities are not treated as expenditures for a Significant Capital Improvement under Part IV.B.7.b.1) or 2) if a board without the enhanced capability is not readily available or if for other reasons it would not have been cost-effective to replace the worn board with a board that did not have the enhanced capabilities.

d. Examples of Significant Capital Improvements. ¹⁰⁵

1) Assumption. In these examples, unless otherwise stated, it is assumed that an expenditure is not for a Significant Capital Improvement as a result of Part IV.B.7.b.5) regarding expenditures for replacement of a part in or component or portion of an asset.

2) Example (1). B pays or incurs expenditures for the repair, maintenance, rehabilitation, or improvement of various assets. Expenditures for the following are expenditures for Significant Capital Improvements: (i) modifying a metal fabricating machine and replacing certain parts to increase the capacity of the machine by more than twenty-five percent (increased capacity under Part IV.B.7.b.2)); and (ii) replacing a lathe, the retirement of which resulted in recognition of gain or loss (replacement of a retired asset for which gain or loss is recognized under Part IV.B.7.b.5). Expenditures for the following are not expenditures for Significant Capital Improvements: (i) inspecting, oiling, adjusting, cleaning, and painting; (ii) replacing bearings and gears in a lathe; (iii) replacing an electric starter with a new starter of substantially the same capacity; (iv) replacing certain electrical wiring in an automatic drill press; and (v) repairing a metal fabricating machine if the repairs do not increase the capacity or productivity of the machine by twenty-five percent or more.

3) Example (2). Corporation M operates a steel plant that produces rails, blooms, billets, special bar sections, reinforcing bars, and large diameter line pipe. Expenditures for the following are expenditures for Significant Capital Improvements: (i) placing in service twenty new ingot molds (an expenditure to acquire a new asset under Part IV.B.7.b.4)); (ii) replacing a roll stand in a twenty-inch bar mill (an expenditure for replacement of a retired item under Part IV.B.7.b.5)); and (iii) overhauling an eleven-inch bar mill and reducing stands, which increased billet speed from 1,800 feet per minute to 2,300 feet per minute (more than twenty-five percent increase over original productivity under Part IV.B.7.b.1)). Expenditures for the following are not expenditures for Significant Capital Improvements: (i) relining an open-hearth furnace; (ii) replacing one reversing roll in a blooming mill if the retirement of the reversing roll does not give rise to gain or loss; and (iii) overhauling a rail and billet mill if the overhaul does not increase capacity or productivity of the mill by twenty-five percent or more.

4) Example (3). Corporation X pays or incurs expenditures for the repair, maintenance, rehabilitation, or improvement of various assets. Expenditures for the following are expenditures for Significant Capital Improvements: (i) expanding a loading dock from 600 square feet to 750 square feet (an addition to a building or structure under Part IV.B.7.b.6)); and (ii) replacing columns and girders supporting a second story loft storage area in a building to permit storage of supplies with a gross weight that is fifty percent greater than the weight the replaced columns and girders were designed to support (increased capacity under Part IV.B.7.b.2)). Expenditures for the following are not expenditures for Significant Capital Improvements: (i) repainting the exterior of a terminal building; (ii) replacing two window frames and panes in the warehouse; and (iii) replacing two roof girders in a factory building, which does not increase the capacity or productivity of the factory by twenty-five percent or more.

5) Example (4). Corporation A owns and operates an office building. The building has ten elevators, five of which are manually operated and five of which are automatic. Expenditures for replacing the five manually operated elevators with high-speed automatic elevators are expenditures for a Significant Capital Improvement (replacement of a retired asset under Part IV.B.7.b.5)). Expenditures for replacing the cable in one of the automatic elevators are not expenditures for a Significant Capital Improvement.

6) Example (5). Taxpayer W, a cement manufacturer, incurs expenditures to modify and maintain assets. The expenditures do not increase the productivity or capacity of the assets by twenty-five percent or more. Expenditures for the following are expenditures for Significant Capital Improvements: (i) placing in service a new apron feeder and hammer mill (an expenditure for acquiring a new asset under Part IV.B.7.b.4)), and (ii) installing additional dust collectors (an expenditure for acquiring a new asset under Part IV.B.7.b.4)). Expenditures for the following are not expenditures for Significant Capital Improvements: (i) replacing eccentric-bearing, spindle, and wearing surface in a gyratory crusher; (ii) replacing four buckets on a chain bucket elevator; (iii) relining the refractory surface in the burning zone of a rotary kiln; and (iv) replacing two sixteen-inch by ninety-foot belts on a conveyer system.

C. Other expenditures relating to the repair, maintenance, rehabilitation, or improvement of assets.

1. General rule. If a taxpayer does not elect MRAS or MRAS does not apply to an expenditure, the taxpayer must capitalize the expenditure if the expenditure (1) materially increases the value of an asset, (2) materially extends the useful life of an asset, or (3) modifies an asset and makes it suitable for a new or substantially different use. The manner of determining whether an expenditure is required to be capitalized as an improvement to an asset is the same for expenditures made by a lessee and for expenditures made by an owner.

2. Material increase in value.

a. General rule. An expenditure that materially increases the value of an asset is a capital expenditure. An expenditure incurred to keep an asset in an ordinarily efficient operating condition over the expected economic useful life of the asset does not materially increase the value of the asset. An expenditure materially increases the value of an asset only if the value of the asset after the expenditure is substantially greater than the value of the asset prior to the condition that necessitated the expenditure. ¹⁰⁶ Thus, the fact that an expenditure materially increases the value of the asset as compared to its value immediately before the expenditure is not relevant. The magnitude of the expenditure is not dispositive. A requirement by a regulatory authority that the taxpayer make the expenditure to continue to operate the asset also is not dispositive.

b. Conditions taken into account.

1) The condition that necessitates an expenditure may be a sudden event, gradual deterioration, or ordinary wear and tear (e.g., weather, worn paint).

2) For this purpose, the only conditions that may be taken into account are conditions that occurred (i) while the taxpayer owned the property, and (ii) if the taxpayer acquired the property in a section 351 or other nontaxable transaction, while the transferor owned the property. ¹⁰⁷

3) Examples.

a) The taxpayer, a water company, incurs expenditures to reline its pipes. The expenditures are incurred twenty-five years into the pipes' forty-year estimated useful life in response to a fifty- percent reduction in carrying capacity. The expenditures do not materially increase the value of the pipes because the expenditures do not increase the carrying capacity of the pipes as compared to their original capacity.

b) The taxpayer, a manufacturer, built a manufacturing plant near a river. Ten years after the plant was placed in service, the plant experienced a series of major cave-ins, and sinkholes began to appear. In response, the taxpayer incurred significant expenditures for drilling and grouting, without which the taxpayer would have had to abandon its plant. The expenditures did not materially increase the value of the plant because, as a result of the expenditures, the plant did not function in a better or improved way as compared to its original status prior to the cave-ins and sinkholes.

c. Improved materials.

1) The replacement of materials with new materials that, due to product enhancements or technological improvements, are superior in quality to the replaced materials, but otherwise perform substantially the same function as the replaced materials, does not, without more, result in a material increase in the value of an asset. ¹⁰⁸ See also Part IV.C.3.c.

2) Examples.

a) A building exterior is repainted with paint that is superior in quality due to product improvements (e.g., enhanced weatherproofing capabilities). Any increase in value attributable to the superior quality of the paint is not a material increase in value.

b) The original heating pipes in a building must be replaced due to wear and tear. The pipes are replaced with a substantially improved material, but the pipes otherwise serve the same function. Any increase in value resulting from the new material is not a material increase in value.

c) The taxpayer, an aluminum smelter, for over forty years used concrete sub-floors strengthened with iron rebar overlaid with bricks for insulation and employed a full-time brick replacement crew to maintain the integrity of the brick insulation. Due to the introduction of mechanical equipment and other factors, the brick layer became so worn that it was hazardous. The taxpayer incurred expenditures to replace all sections of the brick layer with Fondag cement as an insulator. In comparison to brick, Fondag cement is a much superior material for insulating, is much easier to repair, and becomes electrically nonconductive in twenty-four hours compared to seven or more days for brick. The expenditures materially increased the value of the taxpayer's smelting room floor due to the significantly enhanced capabilities after replacement of the brick layer. ¹⁰⁹

d. Casualty losses. To the extent the condition that necessitates an expenditure also results in a casualty loss deduction under section 1.165-7 of the regulations, (i) the value of property after the expenditure is compared with (ii) the value of the property immediately before the casualty reduced by the amount of the casualty loss deducted by the taxpayer. ¹¹⁰

e. Hazardous conditions.

1) If a taxpayer, in the ordinary course of operating a business, creates an environmentally hazardous condition, costs incurred by the taxpayer to eliminate or control the hazardous condition, other than costs to produce or acquire assets as defined in Part III.B.2., do not materially increase the value of the asset. ¹¹¹

2) Examples.

a) Taxpayer X bought uncontaminated land, built a factory, and for twenty years conducted manufacturing operations that resulted in soil contamination. To comply with environmental requirements, X remediated the contaminated soil. X excavated the contaminated soil, transported it to waste disposal facilities, and backfilled the excavated areas with uncontaminated soil. X's soil remediation expenditures do not result in improvements that materially increase the value of X's property. ¹¹²

b) The facts are the same as in a), but X also constructed groundwater treatment facilities, which included wells, pipes, pumps, and other equipment to extract, treat, and monitor contaminated groundwater. The groundwater treatment facilities will remain in operation on X's land for approximately twelve years. X will continue to use the land and operate the plant in the same manner as it did prior to the cleanup except that X will dispose of any hazardous waste in compliance with environmental requirements. The costs of constructing the groundwater treatment facilities are capital expenditures. The ongoing costs of operating the groundwater treatment facilities are deductible as incurred.

c) The taxpayer incurred expenditures to install and seal a permanent containment facility for waste products generated by the taxpayer's prior business. The expenditures do not materially increase the value of an asset, but merely control an environmentally hazardous condition caused by the taxpayer in the course of operating its business. ¹¹³

d) Taxpayer X contaminated soil in connection with its manufacturing operations. Subsequently, X transferred the contaminated property to Y, a wholly owned subsidiary, in a transaction qualifying under section 351. None of Y's soil remediation expenditures materially increase the value of the property because, even though Y did not cause the hazardous condition, Y is treated as stepping into the shoes of X as to the treatment of its expenditures to remediate the contaminated property.

e) The taxpayer, a steel manufacturer, operated a plant with a 100-foot smokestack. The taxpayer incurred expenditures to add fifty feet to the smoke stack. The expenditures are capital expenditures because the expenditures do not relate to the elimination or control of a hazardous condition previously caused by the taxpayer and because the expenditures materially add to the value of the taxpayer's property.

3. Material extension of useful life.

a. General rule. An expenditure that materially extends the economic useful life of an asset is a capital expenditure. An expenditure incurred to keep an asset in an ordinarily efficient operating condition over the expected economic useful life of the asset does not materially extend the economic useful life of the asset. An expenditure materially extends the economic useful life of an asset if the economic useful life of the asset after the expenditure is substantially greater than the economic useful life of the asset prior to the condition that necessitated the expenditure. ¹¹⁴ The magnitude of the expenditure is not dispositive. A requirement by a regulatory authority that the taxpayer make the expenditure to continue to operate the asset also is not dispositive.

b. Measurement of economic useful life. The economic useful life of an asset is determined by reference to the period over which the asset may (at the time of the acquisition) reasonably be expected to be useful to the taxpayer in its trade or business or in the production of income taking the following factors into account: ¹¹⁵

1) Wear and tear and decay or decline from natural causes;

2) The climatic and other local conditions peculiar to the taxpayer's trade or business; and

3) The taxpayer's policy as to repairs, renewals, and replacements.

c. Improved materials. The replacement of materials with new materials that, due to product enhancements or technological improvements, are superior in quality to the replaced materials, but otherwise perform substantially the same function as the replaced materials, does not, without more, result in a material extension of the economic useful life of an asset. ¹¹⁶ See also Part IV.D.2.c.

d. Re-evaluation of economic useful life.

1) The economic useful life of an asset is not materially increased for this purpose if the expected economic useful life is extended by technological advancements in repair technology or similar factors.

2) Examples.

a) The taxpayer is a common carrier operating a fleet of tractor-trailers. Within the last five years, cumulative improvements in diesel fuel technology have substantially reduced engine wear, such that the estimated economic useful life of the taxpayer's tractor-trailer engines is, on average, ten years longer than it was five years ago, and the taxpayer may now perform up to ten rather than eight overhauls before having to replace an engine. The expenditures for the last two overhauls do not materially increase the economic useful life because the increase in the economic life of the tractor-trailers is a result of improvements in technology.

b) The taxpayer, a commercial airline, is periodically required to retread the tires used on its aircraft for landing and taxiing. On average, a tire has to be completely replaced after four retreading cycles, which results in an average useful life of two and one-half years. As a result of improvements in retreading technology, the average life of the tires is extended such that the tires will now remain functional through five to six retreading cycles. The expenditures for applying the new retreading technology to existing tires are not considered to increase the economic useful life of the taxpayer's tires.

4. Examples of application of material increase in value and material increase in useful life tests.

a. Example (1). Taxpayer B, using competent engineers and other professionals, constructed a factory. Fifteen years later, a previously undiscovered geological defect caused the floor of B's factory to cave in. B incurred costs to repair the damage resulting from the cave-in and soil drilling and grout injection costs to minimize the adverse effects of the geological defect. As a result of these expenditures and the adoption of a continuing inspection and maintenance program, B was able to continue to use its factory. The life and value of the B's property after the repair was not greater than the life and value of the property prior to the condition that necessitated the repair (i.e., the cave-in). The costs of the repair are deductible. ¹¹⁷

b. Example (2). Taxpayer C purchased a factory that was leased to a tenant. Two years later, to stop water leaks that had developed, C repaired the roof and removed the old concrete windowsills. C then repaired, straightened, and painted the steel window sashes. Although C did not replace any major component, such as the roof, a wall, or a floor, the cost of the repairs was approximately thirty-five percent of the fair market value of the building. The work done was a normal response to the leaks, to permit continued use of the building. The repairs did not increase the original economic useful life of the property and the value of the property after the repair was not greater than the value of the property prior to the condition that necessitated the repair (i.e., the leaks). The repair costs are deductible. ¹¹⁸

c. Example (3). Six years after purchasing a used loader, E replaced the malfunctioning transmission in the loader with a used transmission that had not been rebuilt or reconditioned and was only guaranteed to operate on installation. In addition, the rod bearings on two engine cylinders failed. Rather than replacing only the two failed cylinders, E replaced all of the major parts of the engine, except the block. Without the complete replacement, the loader engine would have had a remaining economic useful life of ten years, but the expenditure increased the useful life by five years. The transmission repair was not undertaken to increase the value or life of the loader and the cost is deductible. The engine replacement materially extended the life of the loader and capitalization of the cost is required. ¹¹⁹

d. Example (4). The facts are the same as in Example (3), except that the Taxpayer, E, did not own, but leased the loader for use in its trade or business and incurred the expenditures at the end of year six of a fifteen-year renewable lease term. In this situation, E's expenditure for the engine replacement materially extended the engine's life because the expenditures increased the period in which the asset could be used by the taxpayer for the purposes for which it was acquired even though the taxpayer may not use the asset beyond the original lease term. E's expenditures for the engine replacement are required to be capitalized. E may deduct the cost of the transmission repair.

e. Example (5). A factory owned by taxpayer F was severely damaged by a flood. F had no flood insurance and incurred costs to restore the factory to its pre-flood condition. The expenditures returned F's factory to the state it was in before the flood. The expenditures did not make the property more valuable, suitable for a new use, or longer lived. The expenditure did not materially enhance the value, use, life expectancy, strength, or capacity of the factory as compared with its status prior to the flood. If F claimed a casualty loss deduction for the flood damage, the amount of the deduction for the expenditures should be determined by comparing (i) the value of F's factory before the flood less the casualty loss deducted and (ii) the value of F's factory after the repair. The expenditures should be capitalized to the extent that (ii) exceeds (i). If F did not claim a casualty loss deduction for the flood damage, the repairs did not increase the original economic useful life of the property, and the value of the property after the repair was not greater than the value of the property prior to the condition that necessitated the repair, then the entire expenditure is deductible. ¹²⁰

f. Example (6). During the second year after a manufacturing plant was placed in service, taxpayer G began to experience leaks in different parts of the roof, which was covered with perlite, asphalt and gravel. After repairing the leaks five to six time per year for several years, the contractor responsible for initially installing the roof refused to make further repairs. G then incurred expenditures to correct the leaks and eliminate the need for constant repairs. The work consisted of removing the asphalt, gravel, and perlite, and inserting a wood-framed copper expansion joint, covered with fiberboard, asphalt and gravel, which was the most economical way to repair the leaks and keep the leased property in an ordinarily efficient operating condition. None of the expenditures materially increase the value of the property because they do not materially increase the value of the property compared to the value of the property before the condition that necessitated the expenditure. ¹²¹

5. New or substantially different use. An expenditure that modifies an asset and makes it suitable for a new or substantially different use is a capital expenditure. See Part IV.B.7.b.3).

6. Per se deductible expenditures.

a. Recurring restoration expenditures.

1) Expenditures to arrest deterioration that are reasonably expected to occur on a regular and recurring basis are per se deductible.

2) Recurring restoration expenditures do not include expenditures for repairs that are made because of obsolescence.

3) Examples.

a) Example (1). Taxpayer A acquired an operating hotel in a "tired" condition because repairs had been deferred. While continuing to operate the hotel, Taxpayer A incurred expenditures to paint, repaper and make other similar repairs to the public areas in the hotel and two-thirds of the rooms in the hotel. In operating any first-class hotel, similar repairs are required every three to five years over the estimated thirty-year life of the hotel to remain competitive and to keep the hotel in efficient operating condition. The expenditures are deductible. ¹²²

b) Example (2). Taxpayer B boiled sugar in a nine-foot cast iron evaporator that contained 2,400 copper tubes. The tubes had to be (i) descaled frequently due to corrosion caused by sugar and (ii) replaced every two to four years. Replacement of the tubes did not increase the value of the evaporator compared to the value before the tubes were damaged by the sugar. Replacement of the tubes did not extend the twenty-year estimated useful life of the evaporator. The expenditures for replacement of the tubes are deductible. ¹²³

b. Inspection activity expenditures. Inspection costs are currently deductible provided that the inspection is performed primarily to inspect the property for damage, wear, or other defects. Inspection costs meeting the foregoing criteria are currently deductible even if, as a result of the inspection, substantial capital expenditures are required to be made.

c. Removal costs.

1) Costs incurred in connection with the removal of an asset or component of an asset are currently deductible if either (a) gain or loss is recognized by the taxpayer with respect to the adjusted basis of the removed asset or component (or would be recognized by the taxpayer but for (i) a special non-recognition provision of the Code or section 1.1502-13 of the regulations or (ii) the fact that the cost of the asset or component has been fully recovered through an allowance for depreciation), or (b) the costs are incurred in connection with other costs if such other costs constitute a currently deductible repair under any other rules of Part IV.D. ¹²⁴ To the extent that the taxpayer incurs costs in connection with a plan of rehabilitation involving the property, removal costs shall not be considered incurred by reason of such plan within the meaning of Part IV.C.7.d.

2) Example (1). The taxpayer, a telecommunications service provider, upgraded the network through which it provides telecommunications services by deploying new more technologically advanced switching equipment including computerized mainframe equipment used to route telephone calls and data transmissions. On January 15, 2000, the taxpayer installed the new equipment in its central offices, adjacent to existing equipment. The old and new equipment operated in tandem in the central office through July 15, 2000. On that date, the taxpayer incurred costs to remove the old equipment from the central office. The costs of removing the old equipment are currently deductible regardless of whether the removal of the existing equipment occurs in connection with the installation of the new equipment.

3) Example (2). The taxpayer owns and operates a building used as a hotel. The hotel was first placed in service in 1983. In 2000, the taxpayer converts the building from a hotel to an office building. In connection with this project, the taxpayer incurs costs to remove and dispose of significant portions of the interior plumbing that are not usable for the new building's office configuration. Because the removed interior plumbing fixtures are not properly treated for purposes of section 168 as assets that are separately depreciable from the remainder of the building's structure, such costs do not qualify as deductible removal costs.

7. Plan of rehabilitation.

a. General rule. All costs that are incurred by reason of a plan of rehabilitation are required to be capitalized as an improvement to the asset to which such costs relate.

b. Plan of rehabilitation defined.

1) A plan of rehabilitation includes expenditures that are incurred by reason of a plan relating to an asset if the plan includes expenditures that meet the following requirements:

a) Capital expenditures involving substantial capital improvements such as replacements of major components and significant portions of substantial structural parts of the asset;

b) Capital expenditures that result in a material increase in the value and substantially prolong the useful life of the asset or modify the asset and make it suitable for a new or substantially different use;

c) Repair expenditures that are incidental to the plan; and

d) The purpose of the work that resulted in the expenditures was to put the asset in an ordinarily efficient operating condition rather than merely to keep the asset in an ordinarily efficient operating condition. ¹²⁵

2) Additional requirements. A plan of rehabilitation exists only if it involves planned expenditures for both substantial capital improvements and repairs to the same asset. A plan of rehabilitation does not exist if the plan primarily involves repair and maintenance items, none of which would be considered substantial capital improvements standing alone. In addition, a plan of rehabilitation does not exist if the expenditures include the replacement of numerous parts of an asset but the parts replaced do not consist of major components or significant portions of substantial structural parts of the asset. The existence of a written plan, by itself, is not sufficient to constitute a plan of rehabilitation.

c. Costs incurred by reason of a plan of rehabilitation. Costs are considered incurred by reason of a plan of rehabilitation if they are incurred in connection with the plan and are reasonably proximate in time to the capital expenditures that resulted in the existence of the plan of rehabilitation. Costs that meet the preceding criteria are considered incurred by reason of the plan of rehabilitation and are thus required to be capitalized even though, standing alone, such costs would be currently deductible as repair and maintenance costs. ¹²⁶ Removal costs within the meaning of Part IV.C.5.c are not considered costs incurred by reason of a plan of rehabilitation.

d. Examples.

1) X decided to make substantial improvements to an aircraft, which was twenty-two years old and nearing the end of its anticipated useful life, for the purpose of increasing its reliability and extending its useful life. X's improvement of the aircraft involved many modifications to the structure, exterior, and interior of the airframe. The modifications included removing all the belly skin panels on the aircraft's fuselage and replacing them with new skin panels; replacing the metal supports under the lavatories and galleys; removing the wiring in the leading edges of both wings and replacing it with new wiring; removing the fuel tank bladders, harnesses, wiring systems, and connectors and replacing them with new components; opening every lap joint on the airframe and replacing the epoxy and rivets used to seal the lap joints with a non-corrosive sealant and larger rivets; reconfiguring and upgrading the avionics and the equipment in the cockpit; replacing all the seats, overhead bins, sidewall panels, partitions, carpeting, windows, galleys, lavatories, and ceiling panels with new items; installing a cabin smoke and fire detection system, and a ground proximity warning system; and painting the exterior of the aircraft. The work performed on the aircraft also included modifications necessary to terminate every aging aircraft airworthiness directive issued by the Federal Aviation Administration (FAA) that was applicable to the aircraft. In order to upgrade the airframe to the desired level, X performed much of the same work that would be performed during a heavy maintenance visit. ¹²⁷

The work performed on the aircraft involved replacements of major components and significant portions of substantial structural parts that materially increased the value and substantially prolonged the useful life of the airframe. In addition, the value of the aircraft was materially increased as a result of material additions, alterations and upgrades that enabled X to operate the aircraft in an improved way.

X performed much of the same work on the aircraft that would be performed during a heavy maintenance visit. These costs, standing alone, or incurred in connection with capital expenditures that do not involve replacements of major components and significant portions of substantial structural parts of the airframe, are currently deductible expenses under section 162. However, in this context, they are incurred as part of a general plan of rehabilitation, modernization, and improvement to the airframe of the aircraft and X is required to capitalize under section 263 the costs of that work. In this situation, X planned to perform substantial capital improvements to upgrade the airframe of the aircraft for the purpose of increasing its reliability and extending its useful life. The heavy maintenance visit type work was incidental to X's plan to upgrade the aircraft. The effect of all the work performed on the aircraft, including the inspection, repair, and maintenance items, is to materially increase the value of the airframe and substantially prolong its useful life. Thus, all the work performed by X on the aircraft is part of a general plan of rehabilitation, modernization, and improvement to the airframe and the costs associated with this work must be capitalized under section 263. ¹²⁸

2) The taxpayer is engaged in the barge transportation business and operates a fleet of owned and leased towboats ranging in age from seven to thirty-seven years. With proper maintenance, a towboat's engines can continue to operate safely, efficiently, and profitably as part of the main propulsion system for up to forty years. After a towboat has been operated 25,000 to 35,000 hours, the taxpayer, in accordance with the manufacturer's maintenance manual, cleans and inspects the engines to determine which parts are within acceptable operating tolerances and can be reused and which (if any) parts need to be reconditioned or replaced because they show wear. A towboat is used an average of 8,000 hours per year such that the maintenance must be repeated every three to four years. The disassembly, inspection and cleaning procedures involve over ninety percent of each engine's parts. With respect to one group of its engines, the taxpayer only replaced or repaired those parts that had shown wear. With respect to these engines, the taxpayer's maintenance activities do not involve a plan of rehabilitation because the expenditures consist solely of currently deductible recurring restoration expenditures as defined in Part IV.C.6.c. and currently deductible inspection activity expenditures as defined in Part IV.C.6.d. ¹²⁹

² See, e.g., sections 368(a)(1)(A), (B), (C), (D) and 368(a)(2)(D), (E).

³ See, e.g., sections 355 and 368(a)(1)(D), (E).

⁴ See e.g., Richmond Television Corp. v. U.S., 345 F.2d 901 (4th Cir. 1965), vacated on other grounds, 382 U.S. 68 (1965), original holding on this issue reaff'd, 354 F.2d 410 (4th Cir. 1965) (training costs incurred prior to the time the taxpayer was granted a license by the FCC to operate a television station had to be capitalized as pre-opening expenses); Radio Station WBIR v. Comm'r, 31 T.C. 803 (1959) (same for legal and engineering fees, travel and other expenses incurred prior to obtaining broadcast license); KWTX Broadcasting Co. v. Comm'r, 31 T.C. 952 (1959), aff'd per curiam, 272 F.2d 406(5th Cir. 1959) (same); Petersburg Television Corp. v. Comm'r, 20 T.C.M. 271 (1961) (same for salary, travel expenses, and professional fees).

⁵ It is important to note that this position is inconsistent with Cleveland Electric Illuminating Co. v. U.S., 7 Cl. Ct. 220 (1985). We believe that the analysis and conclusion reached in Cleveland Electric are out of harmony with other decisions in this area, including, for example, Briarcliff Candy Corp. v. Comm'r, 475 F.2d 775 (2d Cir. 1973), NCNB Corp. v. U.S., 684 F.2d 285 (4th Cir. 1982), and Colorado Springs Nat'l Bank v. U.S., 505 F.2d 1185 (10th Cir. 1974). A new technological development affecting the taxpayer's core business operations does not necessitate capitalization.

⁶ See Bank Holding Company Act of 1956 section 4(k), 12 U.S.C. 1843(k) (defining conduct of a banking, financing, or similar business to include investment banking, merchant banking, underwriting securities, selling securities as a broker or dealer, underwriting insurance, selling insurance, or being an insurance broker).

⁷ See section 195; Rev. Rul. 99-23, 1999-20 I.R.B. 3.

⁸ See Ellis Banking v. Comm'r, 688 F.2d 1376 (11th Cir. 1982) (accounting fees incurred to investigate financial condition of corporation in preparation for proposed stock acquisition were capital expenditures); Rev. Rul. 69-330, 1969-1 C.B. 51 (accounting costs incurred for SEC registration of stock were nondeductible capital expenditures); see also Thompson & Green Machinery Co. Inc. v. Comm'r, 327 F. Supp 1128 (M.D. Tenn. 1971) (requiring capitalization of legal and accounting fees incurred in connection with change in corporate structure), acq., 1956-2 C.B. 5, 7; Frankford-Quaker Grocery Co. v. U.S., 353 F. Supp. 93 (E.D. Penn. 1972) (failure to consummate statutory merger did not preclude capitalization of expenses because taxpayer accomplished beneficial combination that merger would have effected in another manner).

⁹ See Rev. Rul. 99-23, 1999-20 I.R.B. 3 (costs of appraisals of assets and detailed examination of party's books and records for purpose of establishing price facilitated transaction and were capital expenditures).

¹⁰ See Denver & Rio Grande W. R.R. Co. v. Comm'r, 32 T.C. 43 (1959) (capitalization required for "expenses incurred in the authenticating, printing, and listing by the petitioner of three sets of bonds"), acq., 1959-2 C.B. 4, aff'd on other issues, 279 F.2d 368 (10th Cir. 1960); Rev. Rul. 75-172, 1975-1 C.B. 145 (capitalization required for nonrefundable fee paid for lender's construction and architectural inspection, site planning, and engineering services performed in connection with making loan, legal fees and other costs incurred by lender in obtaining loan proceeds through issuance of its notes and bonds); Rev. Rul. 70-360, 1970-2 C.B. 103 (capitalization required for commissions and bank charges for negotiation of loan and issuance of bonds).

¹¹ See Rev. Rul. 70-360, 1970-2 C.B. 103 (capitalization required for commissions and bank charges for negotiation of loan and issuance of bonds).

¹² See Rev. Rul. 70-360, 1970-2 C.B. 103 (capitalization required for commissions and bank charges for negotiation of loan and issuance of bonds); Davis v. Comm'r, 151 F.2d 441 (8th Cir. 1945) (underwriter commissions were capital expenditures).

¹³ See Von Muff v. Comm'r, 46 T.C.M. 1185 (1983) (loan origination fees and escrow charges deductible ratably over term of loan); Rev. Rul. 81-160, 1981-1 C.B. 312 (commitment fees or standby charges under bond agreement to make stated amounts available over specified period are deductible ratably over loan term); Rev. Rul. 81-161, 1981-1 C.B. 313 (commitment fee amortized over loan term).

¹⁴ See Von Muff v. Comm'r, 46 T.C.M. 1185 (1983) (loan origination fees and escrow charges deductible ratably over term of loan).

¹⁵ See Davis v. Comm'r, 151 F.2d 441 (8th Cir. 1945) (SEC registration fees were capital expenditures).

¹⁶ See Part II.C. above, which provides guidance for determining whether a taxpayer has entered into a new separate trade or business or expanded its existing trade or business. If a taxpayer has expanded its existing trade or business, see Part II.D.3.c.(10) below for treatment of investigatory costs incurred in connection with an expansion of an existing trade or business.

¹⁷ See section 195; Rev. Rul. 99-23, 1999-20 I.R.B. 3. The following examples, drawn from Rev. Rul. 99-23, 1999-20 I.R.B. 3, illustrate the definition of investigatory costs:

Example 1: The taxpayer engaged an investment banker in April 1998 to evaluate a possible acquisition of a trade or business unrelated to its existing business. The investment banker researched publicly available financial and industry information. Eventually, the taxpayer focused on a single industry. The investment banker then researched a variety of entities within that industry, including the corporation ultimately selected as an acquisition target (V), as well as its competitors. Appraisal and other costs were incurred in determining a fair purchase price for V. On November 1, 1998, the taxpayer entered into an acquisition agreement with V. Costs attributable to conducting the industry research and the review of publicly available financial information related are investigatory costs eligible for amortization as start-up costs under section 195. The costs incurred to evaluate V and its competitors may be investigatory costs if such evaluation was performed to assist in V's whether and which decisions. If such costs were incurred after such decision had been made, then such costs would be capital expenditures.

Example 2: In May of 1998, the taxpayer commenced the search for a trade or business to acquire. The taxpayer hired an investment banker to research three potential targets and a law firm to draft required regulatory documents. Eventually the taxpayer decided to acquire X and entered into an acquisition agreement on December 1, 1998. The costs incurred to evaluate potential businesses, to the extent they relate to the whether and which decisions are investigatory eligible for amortization under section 195. The costs of drafting required regulatory documents are capital expenditures; even if they are incurred prior to the time the whether and which decisions are made as such costs are incurred to facilitate an acquisition.

Example 3: The taxpayer, in June 1998, hired accountants and attorneys to perform "preliminary due diligence," including financial projection analysis and industry analysis in conjunction with a potential acquisition of Z. In September 1998, a letter of intent, which indicated that no binding commitment would result unless an acquisition agreement was executed, was prepared by the attorneys and submitted to Z. Additional "due diligence" services, which included "a review of Z's internal documents relating to insurance policies, employee agreements, and lease agreements, an in-depth review of Z's books and records, and preparation of an acquisition agreement," were performed. On October 1998, the taxpayer and Z entered into an acquisition agreement. Costs incurred prior to September 1998 related to "preliminary due diligence" are investigatory costs eligible for amortization under section 195 as start-up costs. The "due diligence" costs were provided after September 1998 and were incurred to facilitate the acquisition of Z. Thus, such costs are capitalized under section 263 as costs of acquiring Z.

¹⁸ See Wells Fargo & Co. v. Comm'r, 86 AFTR2d Par. 2000-5217 (8th Cir. 2000). But see Rev. Rul. 99-23, 1999-20 I.R.B. 3 ("once a taxpayer has focused on the acquisition of a specific business, expenses that are related to an attempt to acquire that business are capital in nature. Thus, the 'final decision' referred to in the legislative history of section 195 is the point at which a taxpayer makes its decision whether to acquire a business, and which business to acquire, rather than the point at which a taxpayer and seller are legally obligated to complete the transaction.").

¹⁹ See A.E. Staley Mfg v. Comm'r, 119 F.3d 482, 490 (7th Cir. 1997) (capitalization may be required if investment banker performs some facilitating tasks associated with a particular transaction).

²⁰ See Mills Estate, Inc. v. Comm'r, 206 F. 2d 244 (1953) (denying deductions for legal fees incurred in reorganization of corporation); Rev. Rul. 69-330, 1969-1 C.B. 51 (legal costs incurred for SEC registration of stock were nondeductible capital expenditures); Rev. Rul. 67-401, 1967-2 C.B. 123.

²¹ See Lovejoy v. Comm'r, 18 B.T.A. 1179 (1930) (printing costs incurred in securing long-term loan not currently deductible).

²² See Dana Corp. v. U.S., 174 F.3d 1344 (Fed. Cir. 1999) (taxpayer had fixed liability on January 1 of each year to pay retainer to law firm; if law firm performed legal services for taxpayer during taxable year, taxpayer was permitted to offset retainer against cost of such services; fee deductible if law firm performed no services; if law firm performed services, deductibility of fee depended on nature of services performed).

²³ Cf. Tech. Adv. Mem. 85-16-002 (Dec. 14, 1984) (ruling that: (1) litigation costs incurred to resist tender offer; (2) expenditures incurred in unsuccessful attempt to foil offer; (3) costs associated with unsuccessful attempt to sell taxpayer, or merge it with third party; (4) expenses incurred to inform shareholders of management's opposition to tender offer; and (5) proxy expenses arising from numerous disagreements between taxpayer and a shareholder, are deductible expenses). Tech. Adv. Mem. 85-16-002 was withdrawn for reconsideration by Tech. Adv. Mem. 86-26-001, but was later reinstated by Tech. Adv. Mem. 88-16-005 after "careful and extensive reconsideration." Tech. Adv. Mem. 86-26-001 (Aug. 23, 1985); Tech. Adv. Mem. 88-16-005 (Feb. 13, 1987).

²⁴ See Part I.B. above, which provides that costs within the scope of section 195 are not subject to the principles set forth in this document.

²⁵ See Ellis Banking v. Comm'r, 688 F.2d 1376 (11th Cir. 1982) (costs associated with taxpayer's regular audit functions were deductible).

²⁶ Rev. Rul. 92-80, 1992-2 C.B. 57 (advertising generally deductible, even though it may provide some future benefit to taxpayer's business operations). But see Cleveland Electric Illuminating Co. v. U.S., 7 Cl. Ct. 220 (1985) (capitalization required for advertising costs directed toward obtaining future benefits significantly beyond the benefits traditionally associated with ordinary product, institutional, or goodwill advertising);

²⁷ See, e.g., Capital Indemnity Ins. Co. v. Comm'r, 237 F.2d 901, 903 (7th Cir. 1956) (finding taxpayer's payments to free itself from a burdensome contract to be deductible business expenses); Stuart Co. v. Comm'r, 195 F.2d 176, 177 (9th Cir. 1952 (holding amount allocable to cancellation of onerous contract was properly deductible as ordinary and necessary business expense); Montana Power Co. v. U.S., 171 F. Supp. 943, 945 (Ct. Cl. 1959) (holding payments to cancel a long-term supply contract deductible as ordinary and necessary business expenses); see also T.J. Enterprises Inc. v. Comm'r, 101 T.C. 581, 590 (1993) (explaining expenditures designed to reduce costs generally are deductible). But see Darlington-Hartsville Coca-Cola Bottling v. U.S., 393 F.2d 494 (4th Cir. S.C. 1968) (requiring capitalization of termination fees incurred because contract was terminated to obtain more favorable agreement).

²⁸ See Rev. Rul. 73-146, 1973-1 C.B. 61 (payments to employees to terminate unexercised stock options, as a condition to section 368(a)(1)(B) reorganization, deductible by employer as ordinary and necessary business expenses); Tech. Adv. Mem. 93-26-001 (Mar. 18, 1993) (deduction allowed for payments target made in connection with merger to terminate officers' employment contracts and liquidate directors' non-qualified retirement plan).

²⁹ See Rev. Rul. 94-77, 1994-2 CB 19.

³⁰ See Tech. Adv. Mem. 94-02-004, (Sept. 10, 1993) (generally, if corporation has routinely provided insurance to its directors and officers, insurance policy is pre-paid and provides protection for more than one year, cost deductible ratably over life of policy).

³¹ See Wells Fargo & Co. v. Comm'r, 86 AFTR2d Par. 2000-5217 (8th Cir. 2000); Rev. Rul. 99-23 (expenditures "to determine whether to enter a new business and which new business to enter" qualify as investigatory costs eligible for amortization as start-up expenditures under section 195). If investigatory costs are start-up expenditures under section 195 when a taxpayer is entering into a separate trade or business, such costs are deductible costs when incurred in connection with an expansion of an existing trade or business of the taxpayer.

³² See A.E. Staley Mfg v. Comm'r, 119 F.3d 482, 482 (7th Cir. 1997).

³³ See Dana Corp v. U.S., 38 Fed. Cl. 356 (1997) (retainer fees unrelated to acquisition generally deductible as ordinary and necessary business expense), rev'd on other grounds, 174 F.3d 1344 (Fed. Cir. 1999); Smith v. Comm'r, 36 T.C.M. 932 (1977).

³⁴ See Locke Mfg. Co. v. U.S., 237 F. Supp 80 (D. Conn. 1964) (legal and proxy solicitation expenses associated with resisting insurgent shareholder attempts to take control of management were deductible because management believed resistance in best interests of shareholders), acq., Rev. Rul. 67-1, 1967-1 C.B. 28; Central Foundry Co. v. Comm'r, 49 T.C. 234 (1967) (costs to reimburse shareholders for both successful and unsuccessful proxy fights were deductible), acq., 1968-2 C.B. 2.

³⁵ See A.E. Staley Mfg v. Comm'r, 119 F.3d 482, 490 (7th Cir. 1997).

³⁶ See United States v. Federated Dep't Stores, 171 B.R. 603, 610 (S.D. Ohio 1994) (payments made pursuant to "white knight" agreements as defensive measures against hostile takeover attempts deductible; "INDOPCO does not stand for the princip[le] that any expenditure that merely preserves the existing corporate structure or policy must be capitalized.").

³⁷ See Rev. Rul. 96-62, 1996-2 C.B. 9.

³⁸ See Rev. Proc. 97-27, 1997-1 C.B. 680, section 2.01(1) ("If the practice does not permanently affect the taxpayer's lifetime income, but does or could change the taxable year in which income is reported, it involves timing and is therefore a method of accounting."); Rev. Rul. 90-38, 1990-1 C.B. 57 ("If a taxpayer treats an item properly in the first return that reflects the item, . . . it is not necessary for the taxpayer to treat the item consistently in two or more consecutive tax returns before it has adopted a method of accounting.").

³⁹ See, e.g., Briarcliff Candy Corp. v. Comm'r, 475 F.2d 775, 787 (3d Cir. 1973) ("expenditures for the protection of an existing investment or the continuation of an existing business or the preservation of existing income from loss or diminution, are ordinary and necessary within the meaning of section 162"); T.J. Enterprises, Inc. v. Comm'r, 101 T.C. 581 (1993) (in holding that amounts paid to prevent royalty costs from increasing were deductible, the court wrote, "It is well established that expenses incurred to protect, maintain, or preserve a taxpayer's business, even though not in the normal course of such business, may be deductible as ordinary and necessary business expenses."); Rev. Rul. 2000-4 (in holding that ISO 9000 costs are deductible, the IRS cited Briarcliff with approval).

⁴⁰ As used in this document, the phrase "paid or incurred" assumes that the economic performance rules in section 461 have been satisfied.

⁴¹ See, e.g., Rev. Rul. 92-80, 1992-2 C.B. 57 (advertising costs "are generally deductible under [section 162(a)] even though advertising may have some future effect on business activities, as in the case of institutional or goodwill advertising"); Treas. Reg. section 1.162-1(a) ("advertising and other selling expenses" are deductible); Treas. Reg. section 1.162-20 ("Expenditures for institutional or 'good will' advertising which keeps the taxpayer's name before the public are generally deductible as ordinary and necessary business expenses provided the expenditures are related to the patronage the taxpayer might reasonably expect in the future."); RJR Nabisco Inc. v. Comm'r, T.C. Memo. 1998-252 (advertising costs, including graphic design costs and package design costs, were deductible; the court refused to draw a distinction between the creation of an advertising campaign and the execution of that campaign) nonacq. AOD 1999-012; but see Rev. Rul. 89-23, 1989-1 C.B. 85 (package design costs must be capitalized; "package design" is defined as an asset that is created by a specific graphic arrangement or design of shapes, colors, words, pictures, lettering, and so forth on a given product package, or the design of a container with respect to its shape or function). But see Public Opinion Publishing Co. v. Jensen, 76 F.2d 494 (8th Cir. 1935) (costs incurred by a corporate newspaper publisher in conducting contests to increase subscriptions were capital expenditures). Congress subsequently enacted section 173, which provides that costs of increasing circulation are deductible unless the taxpayer elects to capitalize the expenditures.

⁴² See, e.g., Rev. Rul. 96-62, 1996-2 C.B. 9 ("Amounts paid or incurred for training, including the costs of trainers and routine updates of training materials, are generally deductible as business expenses under [section 162(a)] even though they may have some future benefit."); Ithaca Industries, Inc. v. Comm'r, 97 T.C. 253, 271 (1991), aff'd, 17 F.3d 684 (4th Cir. 1994) (deduction allowed for costs of training new employees to keep the assembled workforce unchanged); Knoxville Iron Co. v. Comm'r, T.C. Memo. 1959-54 (to become more competitive, the taxpayer underwent complete renovation of its production facility and purchased new equipment; costs incurred to train employees to operate the new equipment were deductible); Evans & Howard Fire Brick Co. v. Comm'r, 8 B.T.A. 867 (1927) (costs of training employees to perform their tasks in an existing manufacturing facility more efficiently were deductible); Tech. Adv. Mem. 9645002 (Nov. 8, 1996) (costs of training new employees for new stores as part of a long-term expansion program were deductible). But see Tech. Adv. Mem. 9544001 (July 21, 1995) (costs of developing training manuals and videos that continued to be used in future years and other costs to train workers to be "new technicians" in connection with conversion to just-in-time manufacturing process were capital; taxpayer stated that training costs produced significant long-term benefits).

⁴³ Rev. Rul. 2000-4, 2000-4 I.R.B. 331 ("Costs incurred by a taxpayer to obtain, maintain, and renew ISO 9000 certification are deductible as ordinary and necessary business expenses under section 162, except to the extent they result in the creation or acquisition of an asset having a useful life substantially beyond the taxable year (e.g., a quality manual)."); Rev. Rul. 95-32, 1995-1 C.B. 8 (an electric utility's costs to implement and operate energy conservation and load management program were deductible, despite inclusion of costs in rate base); Goodwyn Crockery Co. v. Comm'r, 37 T.C. 355 (1961), aff'd, 315 F.2d 110 (6th Cir. 1963) (taxpayer had to deduct the cost of a management survey that suggested the employment of a manager and recommended changes in plant and office layout, sales procedures, housekeeping, stock maintenance, inventory control, personnel reorganization, and general operating procedure); Fowler & Union Horse Nail Co. v. Comm'r, 16 B.T.A. 1071 (1929) (cost of moving machinery from old plant to a new plant was deductible, notwithstanding the resulting improvement in internal operations); Evans & Howard Fire Brick Co. v. Comm'r, 8 B.T.A. 867 (1927) (costs of retaining "efficiency engineers" to implement the "Emerson Efficiency System," (a process of improving profitability through more efficient operations that resulted in no tangible additions to the taxpayer's assets and focused primarily on training employees to perform their tasks in an existing manufacturing facility more efficiently) were deductible); Appeal of Schlosse Bros., Inc., 2 B.T.A. 137 (1925) (fees to employ an accountant and systematizer to devise and install a modern cost-accounting system were deductible); but see Tech. Adv. Mem. 9544001 (July 21, 1995) (various costs initially incurred to convert from a "batch" manufacturing methodology to the just-in-time process had to be capitalized).

⁴⁴ See, e.g., Colorado Springs Nat'l Bank v. U.S., 505 F.2d 1185 (10th Cir. 1974) (costs to commence a credit card program by a bank already in the business of lending were deductible); First Security Bank of Idaho v. Comm'r, 592 F.2d 1050 (9th Cir. 1979) (same); Iowa Des Moines National Bank v. Comm'r, 592 F.2d 433 (8th Cir. 1979) (same); First National Bank of South Carolina v. U.S., 558 F.2d 721 (4th Cir. 1977) (same); Equitable Life Ins. Co. v. Comm'r, T.C. Memo. 1997-299 (costs of registering variable annuity contracts with SEC were deductible; although new type of contract was involved, taxpayer already was engaged in the business of selling insurance and annuity contracts).

⁴⁵ The IRS and courts have repeatedly recognized that costs incurred in pursuing potential customers in connection with the operation or expansion of an existing trade or business are currently deductible. See, e.g., Briarcliff Candy Corp. v. Comm'r, 475 F.2d 775 (2d Cir. 1973) (holding deductible costs to solicit storekeepers in the suburbs to sell the products of a taxpayer that previously had sold its products only in the city through owned or leased retail outlets and through department stores); Rev. Rul. 92-80, 1992-2 C.B. 57 (advertising costs are deductible); Rev. Rul. 64-42, 1964-1 C.B. 86 (holding deductible travel expenses abroad to develop foreign markets); Rev. Rul. 56-181, 1956-1 C.B. 96 (holding deductible promotional activities to increase sales); Colorado Springs National Bank v. United States, 505 F.2d 1185 (10th Cir. 1974) (holding deductible expenses incurred by bank in establishing credit card business); Iowa-Des Moines National Bank, 592 F.2d 433 (8th Cir. 1979) (same); First Security Bank of Idaho, N.A. v. Commissioner, 592 F.2d 1050 (9th Cir. 1979) (same); First National Bank of South Carolina v. United States, 558 F.2d 721 (4th Cir. 1977) (same); Three-In-One Oil Co. v. United States, 35 F.2d 987 (Ct. Cl. 1929) (holding deductible advertising that increases sales). See also Rev. Rul. 76-96, 1976-1 C.B. 23 (holding deductible rebates to retail customers); Sun Microsystems v. Commissioner, T.C. Memo. 1993-467, 66 T.C.M. (CCH) 997 (1993) (holding deductible expenses to induce or provide an incentive to existing or potential customers); Convergent Technologies v. Commissioner, T.C. Memo. 1995-320, 70 T.C.M. (CCH) 87 (1995) (same).

Section 173 allows a deduction for costs incurred to establish, maintain, or increase the circulation of a newspaper, magazine, or other periodical. Treas. Reg. section 1.173-1(b)(1) suggests that, absent section 173, "expenditures made in an effort to establish or to increase circulation are properly chargeable to capital account." Such a rule would be inconsistent with authorities such as Briarcliff and would require capitalization of most advertising costs. Furthermore, any rule that would allow a deduction for costs incurred in an effort to keep existing customers but would require capitalization of costs incurred in an effort to get new customers would be inadministrable. We recommend that Treasury and the IRS amend Treas. Reg. section 1.173-1(c) to eliminate any potential implication that business expansion or advertising costs are capital costs.

⁴⁶ See, e.g., Connecticut Light and Power Co. v. Comm'r, 299 F.2d 259 (Ct. Cl. 1963) (gas company's costs of converting customers' appliances to natural gas were deductible; "these expenditures were compelled by sound business practice to protect or retain plaintiff's existing business").

⁴⁸ See, e.g., Tech. Adv. Mem. 9645002 (June 21, 1996) (retail stores); Tech. Adv. Mem. 8423005 (Feb. 8, 1984) (restaurants); Tech. Adv. Mem. 8303012 (Oct. 7, 1982) (manufacturing facilities); NCNB Corp. v. U.S., 684 F.2d 285 (4th Cir. 1982) (bank branch offices).

⁴⁹ See, e.g., Rev. Rul. 76-203, 1976-1 C.B. 45 (a moving and storage company may deduct payments to reimburse uninsured customers for fire losses where made to preserve goodwill and to protect business reputation); Rev. Rul. 56-359, 1956-2 C.B. 115 (insurance broker reimbursed customers for losses when the insurance company he represented failed; costs were deductible expenses of protecting the broker's business by preserving confidence of customers); compare Welch v. Helvering, 290 U.S. 111 (1933) (costs incurred by taxpayers to establish reputation, credit or relations with customers before going into business on their own must be capitalized).

⁴⁹ See, e.g., Montana Power Co. v. U.S., 117 F.2d 394 (Ct. Cl. 1959) (contract termination costs were deductible); Capital Indemnity Insurance Co. v. Comm'r, 237 F.2d 901 (7th Cir. 1956) (same); Stuart Co. v. Comm'r, 195 F.2d 176 (1952) (same); Cleveland Allerton Hotel v. Comm'r, 166 F.2d 805 (6th Cir. 1948) (same); Pressed Steel Car Co. v. Comm'r, 20 T.C. 198 (1953) (same); Metropolitan Co. v. U.S., 176 F. Supp. 195 (S.D. Ohio 1954) (same); Camloc Fastener Company, Inc. v. Comm'r, 10 T.C. 1024 (1948) (same); Cassatt v. Comm'r, 137 F.2d 745 (3rd Cir. 1943) (same); Appeal of Denholm & McKay, 2 B.T.A. 444 (1925) (same); Leib v. Comm'r, T.C. Memo. 1974-272, aff'd, 535 F.2d 1246 (3rd Cir. 1976) (taxpayer could deduct amount incurred to settle litigation because litigation concerned termination of a business relationship). Priv. Ltr. Rul. 199945063 (Nov. 12, 1999) (same); Tech. Adv. Mem. 9548004 (Aug. 9, 1995) (energy conservation costs were deductible); T.J. Enterprises v. Comm'r, 101 T.C. 581 (1993) ("Expenditures designed to reduce costs are . . . generally deductible."); Rev. Rul. 95-32, 1995-1 C.B. 8 ("although . . . expenditures may reduce future operating and capital costs, these kinds of benefits, without more, do not require capitalization. . . ."); Rev. Rul. 94-77, 1994-2 C.B. 19 (employee severance payments are deductible even though severance payments made in connection with a business down-sizing may produce some future benefits, such as reducing operating costs and increasing operating efficiencies).

⁵⁰ See, e.g., Rev. Rul. 2000-7, 2000-9 I.R.B. 712 (cost of removing a utility pole was deductible; capitalization as part of the cost of a replacement pole was not required; ruling inapplicable to removal of component of depreciable asset for which deductibility is determined under the repair rules); Rev. Rul. 94-77, 1994-2 C.B. 19 (employee severance payments are deductible); Comm'r v. Tellier, 383 U.S. 687 (1966) (costs incurred in legal defense of criminal charges arising out of prior business activities were deductible); see also endnote 47, supra.

⁵¹ Rev. Rul. 76-96, 1976-1 C.B. 23 (rebates paid by an automobile manufacturer to qualifying retail customers who purchase or lease new automobiles were deductible by the manufacturer); Fall River Gas Appliance Co. v. Comm'r, 42 T.C. 850 (1964), aff'd, 349 F.2d 515 (1st Cir. 1965) (selling expenses related to appliance sales by a natural gas company were deductible because they "were related to closed transactions and were a proper charge at once against the income realized from such transactions," even though the gas company could expect future sales of gas to the customers of its appliances); Lykes Energy Inc. v. Comm'r, T.C. Memo. 1999-77 (same); Sun Microsystems, Inc. v. Comm'r, T.C. Memo. 1993-467 (issuance of warrants to a new customer to induce them to purchase taxpayer's products were deductible); Convergent Technologies v. Comm'r, T.C. Memo. 1995-320 (same).

⁵² While property acquired for resale is defined to be an "asset," the rules in section 263A apply to determine what costs must be capitalized with respect to the property acquired for resale. See Part I.C.14. See also Part III.C. for similar principles providing that section 263A applies in determining what costs of producing real property or tangible personal property must be capitalized.

⁵³ A line of cases supports the deductibility of payments resulting in a benefit with an economic useful life of less than 12 months. See e.g., Comm'r v. Van Raden, 650 F.2d 1046 (9th Cir. 1981) (payment in December of 1972 for cattle feed calculated to meet the needs of the taxpayer for one year was fully deductible in 1972 even though some of the feed was not consumed until 1974); Zaninovich v. Comm'r, 616 F.2d 429 (9th Cir. 1980) (payment on December 20, 1973, of rent for December 1, 1973, to November 30, 1974, was fully deductible in 1973); Jephson v. Comm'r, 37 B.T.A. 1117 (1938) (premiums paid on a one-year insurance policy that extended into the next taxable year were deductible; premiums paid on a three-year policy were capital); Rev. Rul. 89-62, 1989-1 C.B. 78 (allowing deduction for cost of videocassettes with useful life of one year or less); Rev. Rul. 78-382, 1978-2 C.B. 111 (allowing deduction for cost of rental uniforms in year placed in service because "[m]ost uniforms do not remain in use for 12 months"); Rev. Rul. 73-357, 1973-2 C.B. 40 (allowing deduction for cost of tires with an average useful life of less than one year); Rev. Rul. 69-81, 1969-1 C.B. 137 (allowing deduction for cost of clothing, towels, and other items with a useful life of one year or less); but see USFreightways v. Comm'r, 113 T.C. 329 (1999) (in requiring the taxpayer to capitalize the cost of licenses, fees, and permits with a useful life of less than one year, the court wrote, "widespread support for a rule which would permit near-automatic deduction for costs related to benefits lasting less than one 12-month period is lacking. A second, more fundamental problem with petitioner's argument is that even if such a 1-year rule were widely recognized, it would be inapplicable to an accrual method taxpayer.").

⁵⁴ See, e.g., Rev. Rul. 99-23, 1999-20 I.R.B. 3 (costs of appraisals of assets and detailed examination of party's books and records for purpose of establishing price facilitated transaction and were capital costs).

⁵⁵ See, e.g., Rev. Rul. 70-360, 1970-2 C.B. 103 (capitalization required for commissions and bank charges paid to obtain a loan).

⁵⁶ See, e.g., Rev. Rul. 70-360, 1970-2 C.B. 103 (capitalization required for commissions and bank charges paid to obtain a loan); Davis v. Comm'r, 151 F.2d 441 (8th Cir. 1945) (underwriter commissions were capital expenditures).

⁵⁷ See, e.g., Von Muff v. Comm'r, 46 T.C.M. 1185 (CCH) (1983) (escrow charges deductible ratably over term of loan).

⁵⁸ See, e.g., Lovejoy v. Comm'r, 18 B.T.A. 1179 (1930) (printing costs incurred in securing long-term loan not currently deductible).

⁵⁹ See Ellis Banking v. Comm'r, 688 F.2d 1376 (11th Cir. 1982) (costs associated with taxpayer's regular audit functions were deductible).

⁶⁰ For this purpose, an employee of any member of a group of corporations that files a consolidated income tax return is treated as an employee of each member of the group.

A number of authorities allow taxpayers to deduct employee compensation costs. See, e.g., section 162(a)(1) ("There shall be allowed as a deduction . . . a reasonable allowance for salaries or other compensation for personal services actually rendered. . ."); Treas. Reg. ' 1.162-7(a) ("There may be included among the ordinary and necessary expenses paid or incurred in carrying on any trade or business a reasonable allowance for salaries or other compensation for personal services actually rendered."); Treas. Reg. section 1.162-10(a) ("Amounts paid or accrued within the taxable year for dismissal wages, unemployment benefits, guaranteed annual wages, vacations, or sickness, accident, hospitalization, medical expense, recreational, welfare, or similar benefit plan are deductible under section 162(a) if they are ordinary and necessary expenses of the trade or business."); Wells Fargo Co. v. Comm'r, 224 F.3d 874 (8th Cir. 2000) (taxpayer could deduct officer salary expenses that were directly related to and arose out of the employment relationship and only indirectly related to a corporate acquisition); PNC Bancorp Inc. v. Comm'r, 212 F.3d 822, 830 (3d Cir. 2000), rev'g, 110 T.C. 349 (1998) (bank could deduct employee salaries and benefits attributable to time spent completing and reviewing loan applications, and to other efforts connected with loan marketing and origination); Rev. Rul. 68-561, 1968-2 C.B. 117 (utility allowed to deduct salaries paid to representatives pursuant to a promotional campaign to increase sales of gas); Tech. Adv. Mem. 8423005 (Feb. 8, 1984) (costs to open new restaurants by an existing business were deductible (including salaries of the managers and the opening team, and salaries of the newly-hired employees during their training)); see also Encyclopedia Britannica 685 F.2d 212, 217 (7th Cir. 1982) ("If one really takes seriously the concept of a capital expenditure as anything that yields income, actual or imputed, beyond the period . . . in which the expenditure is made, the result will be to force the capitalization of virtually every business expense. It is a result courts naturally shy away from. . . . It would require capitalizing every salesman's salary, because his selling activities create goodwill for the company and goodwill is an asset yielding income beyond the year in which the salary expense is incurred. The administrative costs of conceptual rigor are too great.").

Under certain circumstances, however, other authorities require taxpayers to capitalize employee compensation costs. See, e.g., Lychuk v. Comm'r, 116 T.C. No. 27 (2001) (taxpayer, who was in the business of acquiring and servicing installment contracts, was required to capitalize the portion of its employee's salaries that was directly related to the successful acquisition of installment contracts); Dunlap v. Comm'r, 74 T.C. 1377 (1980) (taxpayer required to capitalize the portion of its employees' salaries connected with the negotiation of bank acquisitions); San Fernando Mission Land Co. v. Comm'r, B.T.A. Memo. 1942-296, aff'd, 135 F.2d 547 (9th Cir. 1943) (taxpayer employed Mr. New to promote and negotiate oil leases; Mr. New's compensation, which was based on the amount of rental from the 20-year negotiated lease, had to be capitalized); Pier v. Comm'r, 96 F.2d 642 (9th Cir. 1938), aff'g sub nom, Ernest Dupont, 34 B.T.A. 1059 (1936) (stock commission paid to corporate president for consummating a reorganization contract had to be capitalized); Houston Natural Gas Corp. v. Comm'r, 90 F.2d 814, 817 (4th Cir. 1937), aff'g 34 B.T.A. 228 (1936) (taxpayer required to capitalize salaries and expenses of the solicitors employed by it; costs were part of the taxpayer's successful campaign to get new business of a lasting or permanent character); Rev. Rul. 74-104, 1974-1 C.B. 70 (salaries incurred by the taxpayer in evaluating the location of property to be acquired for resale had to be capitalized); Rev. Rul. 73-580, 1973-2 C.B. 86 (the portion of the compensation paid by a corporation to its employees attributable to services performed in connection with corporate mergers and acquisitions must be capitalized); Rev. Rul. 69-331, 1969-1 C.B. 87 (bonuses and commissions paid by a gas distributor to its own salesmen for securing five-year leases for hot water heaters were capital expenditures); Tech. Adv. Mem. 199952069 (Dec. 29, 1999) (costs for employee compensation in connection with soliciting, evaluating, and negotiating five 10-year professional and consulting service contracts required to be capitalized); Field Serv. Adv. 199941008 (Oct. 15, 1999) (in-house fees for terminating an agreement permitting an independent distributor to be the exclusive supplier of taxpayer's merchandise in a specified distribution region had to be capitalized); Tech. Adv. Mem. 9402004 (Sept. 10, 1993) (taxpayer may not deduct as an abandonment loss the portion of its internal payroll costs related to the six unsuccessful potential purchasers where taxpayer was purchased by the seventh party); Gen. Couns. Mem. 36917 (Nov. 10, 1976) (revenue ruling never issued) (Employee salaries incurred by a life insurance company's investment department in connection with the acquisition of mortgage loans and real property were capital expenditures); Gen. Couns. Mem. 35681 (Feb. 19, 1974) ("although . . . as a general rule, administrative or 'in-house' expenditures incurred in originating mortgage loans are currently deductible under Code section 162, . . . any expenditures, whether 'out-house' expenses such as commissions paid to third parties or 'in-house' expenses such as commissions paid to taxpayer's own employees, that are directly related to the acquisition of a mortgage loan must be treated as part of the cost of the loan;" in other words, "where a taxpayer has paid commissions to its own employees, and the commissions played a 'direct and significant part' in the acquisition of capital assets, the Service has determined that the commissions must be capitalized").

Prior to the enactment of section 263A, under section 263, courts required taxpayers to capitalize compensation paid to employees in connection with the construction of assets. See, e.g., Idaho Power v. Comm'r, 418 U.S. 1 (1974) ("Of course, reasonable wages paid in the carrying on of a trade or business qualify as a deduction from gross income. . . . But when wages are paid in connection with the construction or acquisition of a capital asset, they must be capitalized and then entitled to be amortized over the life of the capital asset so acquired."); Chevy Chase Motor Co. v. Comm'r, T.C. Memo. 1977-227 (real estate development company president's compensation attributable to personal direction of construction work required to be capitalized); Acer Realty Co. v. Comm'r, 132 F.2d 512 (8th Cir. 1942) (taxpayer undertook a large program to construct buildings for lease between 1933-1938; instead of having the work done by contractors, the president and secretary- treasurer performed all the services necessary to the management of the construction of the buildings; the president and secretary- treasurer did not receive salaries until 1934; the salaries had to be capitalized); Federal Plate Glass Co., 6 B.T.A. 351 (1927) (taxpayer required to capitalize amounts paid to its general manager and plant superintendent for services over and beyond their usual and customary duties in operating the plant; payments were to obtain their services in supervising the purchase and installation of equipment in the plant); compare Dixie Frosted Foods v. Comm'r, T.C.M. 47145 (1947) (officers of food processing company spent the winter preparing for the next harvest season; part of the preparation involved planning the construction of a new plant; "Such activities as were performed by the officers looking toward the building of expanded facilities were not. . . so extraordinary in character, at that particular stage in the petitioner's venture, or so definitely compensated by any part of the salaries paid to bring these facts within the situation comprehended by the decision in Acer Realty."). See also section 471 (requiring certain compensation costs to be included in the cost of inventory).

⁶¹ See Treas. Reg. section 1.263(a)-2(e) (commission paid by a dealer in selling securities may be treated as ordinary and necessary business expenses); PNC Bancorp v. Comm'r, 212 F.3d 822 (3d Cir. 2000), rev'g 110 T.C. 349 (1998) (costs incurred by bank in originating loans were deductible; costs included: (i) payments made to third parties for activities that help the bank determine whether to approve a loan (credit screening, property reports, and appraisals) and for the recording of security interests when the bank decides to issue a secured loan and (ii) that portion of employee salaries and benefits that can be attributed to time spent completing and reviewing loan applications, and to other efforts connected with loan marketing and origination); but see Lychuk v. Comm'r, 116 T.C. No. 27 (2001) (taxpayer, who was in the business of acquiring and servicing installment contracts, was required to capitalize the portion of its employees' salaries that was directly related to the successful acquisition of installment contracts; the court "respectfully disagree[d]" with the PNC decision and held that the recurring nature of the expenses did not cause them to be deductible); but see Strouth v. Comm'r, T.C. Memo 1987-552 (deduction denied for fees paid by partnership engaged in the business of leasing for leasing company's services in arranging leases).

⁶² See Alabama Coca-Cola Bottling Co. v. Comm'r, T.C. Memo 1969-123 (costs of purchasing and installing signs, scoreboards and clocks had to be capitalized; costs of making repairs, replacing faces, repainting faces and changing the names on signs, scoreboards and clocks were deductible).

⁶³ See Rev. Proc. 2000-50, 2000-52 I.R.B. 601.

⁶⁴ See Miller v. Comm'r, 10 B.T.A. 383 (1928) (a payment by a lessor to terminate a lease must be capitalized as the cost to acquire a capital asset). Costs paid or incurred by a landlord to enter a lease generally must be capitalized. See, e.g., Thielking v. Comm'r, T.C. Memo. 1987-201 ("It is now well settled that commissions paid by a lessor to brokers or agents for securing and negotiating a lease for a term of years are . . . capital expenditures to be amortized over the term of the lease."); Rev. Rul. 70-408, 1970-2 C.B. 68 (brokerage commission paid by a lessor for long-term lease was a capital expenditure); Renwick v. United States, 87 F.2d 123 (7th Cir. 1936) (same regarding 99-year lease); Munger v. Comm'r, 14 T.C. 1236 (1950) (same regarding 5-year oil and gas lease). Gould- Mersereau Co., Inc. v. Comm'r, 21 B.T.A. 1316 (1931) (same regarding 5-year lease); Bonwit Teller & Co. v. Comm'r, 53 F.2d 381 (2d Cir. 1931) (same regarding 21-year lease); Rev. Rul. 69-331, 1969-1 C.B. 87 (same for 5 year leases); Rev. Rul. 81-161, 1981-1 C.B. 313 (fee paid by the developer of a housing complex to a management company to obtain tenants during the "rent-up" period was capital). Similarly, costs paid or incurred by a lessee to enter a lease generally must be capitalized. See, e.g., Rev. Rul. 77-395, 1977-2 C.B. 80 (amounts paid to evaluate land available for lease were capital expenditures); Rev. Rul. 73-421, 1973-2 C.B. 33 (costs incurred by lessee in acquiring a lease (e.g. attorney's fees and legal expenses, bonuses paid for signing the lease, and appraisal costs in connection with obtaining possession of the premises) were capital expenditures); Rev. Rul. 67-141, 1967-1 C.B. 153 (paid for services rendered in connection with the acquisition of government oil and gas leases were capital expenditures); U.S. Bancorp v. Comm'r, 111 T.C. 231 (1998) (charge incurred by a lessee in terminating a lease and simultaneously entering into a new lease was a capital expenditure); Altec Corp. v. Comm'r, 36 T.C.M. (CCH) 1795 (1977) (legal fees expended by a lessee in obtaining a 25-year lease were capital expenditures).

⁶⁵ Costs paid or incurred by a borrower to obtain a loan generally must be capitalized. See, e.g., Rev. Rul. 81-161, 1981-1 C.B. 313 (loan commitment fee paid to a lender for the lender's promise to provide permanent financing was a capital expenditure); Rev. Rul. 70-360, 1970-2 C.B. 103 (expenses incidental to the acquisition of a loan (e.g., commission or brokerage fees charged for a loan, legal expense, and bond issue expense) were capital expenditures); Enoch v. Comm'r, 57 T.C. 781 (1972) (loan fees and escrow charges incurred by the taxpayer in securing loans were capital expenditures); Carlson v. Comm'r, 24 B.T.A. 868 (1931) (commission paid to a trust company for negotiating a loan from a lender was a capital expenditure); S & L Bldg. Corp. v. Comm'r, 19 B.T.A. 788 (1930), rev'd, 60 F.2d 719 (2d Cir. 1932), rev'd, 288 U.S. 406 (1933) (commissions and fees for securing loans were capital expenditures); Lovejoy v. Comm'r, 18 B.T.A. 1179, 1182 (1930) (commissions, fees, and printing costs paid by a taxpayer in securing a loan were capital expenditures). The IRS has taken the position that costs paid or incurred by a lender to enter into a loan must be capitalized. See, e.g., Tech. Adv. Mem. 9024003 (Mar. 2, 1990) (a savings bank must capitalize amounts paid for credit reports, filing and recording fees, attorney fees, and other related closing costs incurred in processing home equity line-of-credit loans; because the loans are separate assets, the costs to create or acquire them are capitalizable and amortizable over the life of the loans); Rev. Rul. 57-400 (holding that "finders fees" (i.e., buying commissions) paid by banks to brokers, title companies, and other third parties for their introduction of acceptable applicants for mortgage loans were capital expenditures); but see PNC Bancorp, Inc. v. Comm'r, 212 F.3d 822 (3d Cir. 2000), rev'g 110 T.C. 349 (1998) ("In the case at bar, the Tax Court concluded without any elaboration that the consumer and commercial loans "clearly" were separate and distinct assets of the banks, . . . . We believe that the Tax Court took too broad a reading of what Lincoln Savings meant by "separate and distinct assets," . . . . The Secondary Reserve fund in Lincoln Savings was a 'separate and distinct asset' in two important ways that distinguish it from FNPC's and UFB's loans, the assets in question here. First, the Secondary Reserve fund was an asset that existed quite apart from Lincoln's main daily business of taking deposits and making loans; second, the fund was an asset that, although it existed within the FSLIC, was nonetheless separate from the FSLIC's other revenues and distinctly earmarked as Lincoln's property. The Tax Court's broad reading of Lincoln Savings essentially treats the term 'separate and distinct asset' as if it extends to cover any identifiable asset. We do not subscribe to this reading of Lincoln Savings.").

⁶⁶ See, e.g., Iowa-Des Moines National Bank v. Comm'r, 68 T.C. 872 (1977), aff'd, 592 F.2d 433 (8th Cir. 1979) (holding capital a one-time $10,000 membership fee incurred by a commercial bank to join a regional association that administered credit card plans; the membership fee is the cost of acquiring a distinct intangible asset). Colorado Springs National Bank v. U.S., 505 F.2d 1185 (10th Cir. 1974) (same); First Security Bank of Idaho, 592 F.2d 1050 (9th Cir. 1979) (same). Compare National Bank of South Carolina, 558 F.2d 721 (bank entering credit card business also could deduct association fees paid to a non-profit association to operate a computer system for credit card transactions).

⁶⁷ Davee v. U.S., 444 F.2d 557 (Ct. Cl. 1971) ("When a properly qualified covenant not to compete for a specified period is entered into as part of the sale of a going business under particular conditions, the portion of the consideration attributable to the covenant is normally taxable as ordinary income to the seller, and the purchaser may deduct the cost over the period of the covenant's ascertainable life."); C.H. Robinson Inc. v. Comm'r, T.C. Memo. 1998- 430 ("Amounts paid for covenants not to compete generally are deductible over the life of the covenants as current business expenses."); O'Dell & Co. v. Comm'r, 61 T.C. 461 (1971) ("It is well settled that when knowledgeable parties execute a covenant not to compete for a limited period in connection with the sale of a business and they expressly assign payments thereto, and when that covenant has economic significance independent of the purchase of the business itself, such a covenant not to compete is a wasting intangible asset in the hands of the covenantee and is depreciable over the course of its useful life.").

⁶⁸ See, e.g., sections 197(d)(1)(D) and (F) (costs incurred to acquire or create a franchise or any license, permit or other right granted by a governmental unit must be capitalized over 15 years); Wells-Lee v. Comm'r, 360 F.2d 665 (8th Cir. 1966) (one-time staff fees paid by doctors so as to be able to practice in a certain hospital were not deductible); Sharon v. Comm'r, 66 T.C. 515 (1976), aff'd, 591 F.2d 1273 (9th Cir. 1978) (costs to be admitted to practice law before various bars were not deductible); Nachman v. Comm'r, 191 F.2d 934 (5th Cir. 1951) (taxpayer paid $8,000 to a third party to purchase a liquor license that was officially issued for $750; although the license expired within the taxable year, the license carried with it by established custom, if not by law, a valuable renewal privilege; the taxpayer had to capitalize $7,250 of its purchase price); compare USFreightways v. Comm'r, 113 T.C. 329 (1999) (accrual method taxpayer had to capitalize costs of licenses, permits, and fees, none of which had a useful life of more than 1 year, but some of which extended into the next taxable year).

⁶⁹ See, e.g., Rodeway Inns of America v. Comm'r, 63 T.C. 414 (1974) (a payment by a taxpayer to terminate an exclusive distribution agreement must be capitalized as the cost to acquire a separate and distinct asset).

⁷⁰ This definition is a variation of the definition in section 1.167(a)-14(c)(3) of the regulations.

⁷¹ This definition is derived from section 1.197-2(b)(1) of the regulations.

⁷² This definition is derived from section 1.197-2(b)(2) of the regulations.

⁷³ This definition is derived from section 1.197-2(b)(3) of the regulations, except that employment contracts have been excluded and are dealt with separately below.

⁷⁴ This definition is derived from section 1.197-2(b)(4) of the regulations.

⁷⁵ This definition is derived from section 1.197-2(5) of the regulations, except that the following intangibles listed in section 197(e) have been excluded: patents, copyrights, computer software, and any interest in a film, sound recording, videotape, book, or other similar property.

⁷⁶ This definition is derived from section 1.197-2(b)(6) of the regulations, except that rights pursuant to contracts (e.g., a contract with a customer, a mortgage servicing contract, and an investment management contract) have been excluded and are dealt with separately below.

⁷⁷ This definition is derived from section 1.197-2(b)(7) of the regulations, except that certain rights arising pursuant to a contract have been excluded and are dealt with separately below.

⁷⁸ But see Houston Natural Gas Corp. v. Comm'r, 90 F.2d 814 (4th Cir. 1937), aff'g 34 B.T.A. 228 (1936), cert. denied 302 U.S. 722 (1937) (costs of paying solicitors and of installing free service lines to customers were capital where the taxpayer's intensive campaign to get new business drove the taxpayer's competitor into receivership, securing for the taxpayer the monopoly of the gas business in Houston); Lykes Energy Inc. v. Comm'r, T.C. Memo. 1999-77 (a gas utility was allowed to deduct subsidies paid to purchasers of its gas appliances because the subsidies related primarily to the income from that sale as opposed to income that was intended to be generated in the future; the utility was required to capitalize promotional or selling expenses unrelated to a specific sale (e.g., feasibility audits, installation subsidies, and energy efficiency audits) because those costs primarily helped the taxpayer increase its customer base and the new customers had a strong incentive to continue their business relationships with the taxpayer because they had made substantial investments to become gas customers); and Fall River Gas Appliance Co., Inc. v. Comm'r, 42 T.C. 850 (1964), aff'd, 349 F.2d 515 (1st Cir. 1965) (a gas utility was allowed to deduct subsidies paid to purchasers of its gas appliances because the subsidies related primarily to the income from that sale as opposed to income that was intended to be generated in the future; the utility was required to capitalize amounts spent for materials and labor to install leased gas appliances; notwithstanding that the taxpayer had no assured benefits because a customer could switch from gas at any time, the taxpayer took considerable risk in anticipation of a continuing economic benefit over an indeterminable length of time - "the totality of expenditure was made in anticipation of a continuing economic benefit over a period of years and such is indicative of a capital expense").

⁷⁹ See Sun Microsystems, Inc. v. Comm'r, T.C. Memo. 1993-467 (issuance of warrants to a new, major customer to induce them to purchase taxpayer's products were deductible; although warrants were part of agreement also involving technology development and a long- term customer relationship that would benefit taxpayer, such future incidental benefit couldn't be a basis for treating warrants as capital items); Convergent Technologies v. Comm'r, T.C. Memo. 1995- 320 (warrants issued by taxpayer to a customer as an incentive to purchase the taxpayer's products was a sales discount excludable from gross income).

⁸⁰ But see Public Opinion Publishing Co. v. Jensen, 76 F.2d 494 (8th Cir. 1935), rehearing denied (costs expended by a corporate newspaper publisher in conducting contests to increase subscriptions were capital expenditures; the circulation of publication is a capital asset, and costs incurred in increasing it are capital expenditures). Congress subsequently enacted section 173, which provides that costs of increasing circulation are deductible unless the taxpayer elects to capitalize the expenditures.

⁸¹ See Briarcliff Candy Corp. v. Comm'r, 475 F.2d 775 (2d Cir. 1973) (deductions allowed for costs associated with one to five year franchise contracts in which "store owners did not agree to sell any minimum amount of candy nor did they guarantee any amount of sales").

⁸² But see Tech. Adv. Mem. 9544001 (July 21, 1995) (costs to convert to just-in-time manufacturing had to be capitalized).

⁸³ See Equitable Life Ins. Co. v. Comm'r, T.C. Memo. 1977-299 (a life insurance company could deduct fees incurred to register new variable annuity contracts with the SEC; although only one registration expense is incurred for any variable contract, such registration fees are "normal, usual, and customary in the day-to-day operations of the insurance business").

⁸⁴ See Comm'r v. Tellier, 383 U.S. 687 (1966) (legal costs "incurred in [taxpayer's] defense against charges of past criminal conduct" arising out of his business activities were deductible).

⁸⁵ Van Idersteine Co. v. Comm'r, 261 F.2d 211 (2d Cir. 1958) (taxpayer paid lump sum to several suppliers to obtain raw materials in a large and steady volume; all the taxpayer acquired was an expectation or hope that it would be preferred over other possible purchasers; the taxpayer had no enforceable contract rights and obtained no rights extending beyond the taxable year of payment; the suppliers could stop selling to taxpayer at any time; the court held the payments were deductible).

⁸⁶ See, e.g., Black Hills Corp. v. Comm'r, 73 F.2d 799 (8th Cir. 1996) (taxpayer purchased insurance covering black lung disease of its coal mine workers; insurance contract front-loaded premiums and required insurer to credit excess premiums for early years to reserve account to be applied in payment of premiums for later years; held premiums must be capitalized to extent they were credited to reserve account); Connecticut Mutual Life Insurance Co. v. Comm'r, 106 T.C. 445 (1996) (contribution by taxpayer to a voluntary employees' beneficiary association (VEBA) trust established to fund the taxpayer's holiday pay obligations for its employees for 8-to-10 years had to be capitalized); Tech. Adv. Mem. 9810001 (Oct. 29, 1997) (contributions to state created catastrophe insurance trust required to be capitalized because trust amounts could only be used to pay future claims against insurance companies); Tech. Adv. Mem. 9402004 (Sept. 10, 1993) (generally, if corporation has routinely provided insurance to its directors and officers, insurance policy is pre-paid and provides protection for more than one year, cost deductible ratably over life of policy).

⁸⁷ Assuming the requirements are otherwise satisfied, a taxpayer who receives such a prepayment in connection with the taxpayer's agreement to provide services may defer the time of its income recognition under Rev. Proc. 71-21, 1971-1 C.B. 549, and a taxpayer who receives such a prepayment in connection with the taxpayer's agreement to provide goods may defer the time of its income recognition under Treas. Reg. section 1.451-5. Similar rules would apply to taxpayers receiving prepayments that might be deferred under other provisions. See, e.g., I.R.C. sections 455, 456.

⁸⁸ See, e.g., Enoch v. Comm'r, 57 T.C. 781 (1972) (loan fees and escrow charges incurred by the taxpayer in securing loans were capital expenditures); Carlson v. Comm'r, 24 B.T.A. 868 (1931) (commission paid to a trust company for negotiating a loan from a lender was a capital expenditure); S & L Bldg. Corp. v. Comm'r, 19 B.T.A. 788 (1930), rev'd, 60 F.2d 719 (2d Cir. 1932), rev'd, 288 U.S. 406 (1933) (commissions and fees for securing loans were capital expenditures); Lovejoy v. Comm'r, 18 B.T.A. 1179, 1182 (1930) (commissions, fees, and printing costs paid by a taxpayer in securing a loan were capital expenditures); Rev. Rul. 81-161, 1981-1 C.B. 313 (loan commitment fee paid to a lender for the lender's promise to provide permanent financing was a capital expenditure); Rev. Rul. 81- 160, 1981-1 C.B. 312 (commitment fees or standby charges incurred pursuant to a bond sale agreement under which funds for construction are made available in stated amounts over a specified period are deductible ratably over loan term); Rev. Rul. 70-360, 1970-2 C.B. 103 (expenses incidental to the acquisition of a loan (e.g., commission or brokerage fees charged for a loan, legal expense, and bond issue expense) were capital expenditures).

⁸⁹ This principle would provide similar amortization of such a right without regard to whether the right was created or acquired separately from a trade or business. See Treas. Reg. section 1.167(a)-14(c).

⁹⁰ Under section 197, the acquisition of a customer-based intangible that is not acquired as part of a purchase of a trade or business is amortized over a period of 15 years. The rule in the text prevents the creation of a customer-based intangible from receiving less favorable treatment than the acquisition of a customer-based intangible.

⁹¹ Peterson v. Comm'r, T.C. Memo. 1987-508 (loan origination fees paid in connection with the acquisition of rental properties had to be capitalized over the term of the loan); Rev. Rul. 75-172, 1975- 1 C.B. 145 (commitment fee incurred in obtaining a construction and permanent mortgage loan is deductible over the period of the loan).

⁹² U.S. Bancorp v. Comm'r, 111 T.C. 231 (1998) (a charge incurred by a lessee in terminating a lease of a mainframe computer and simultaneously initiating a new lease of a more powerful mainframe computer with the same lessor had to be capitalized).

⁹³ See PNC Bancorp v. Comm'r, 212 F.3d 822 (3d Cir. 2000), rev'g 110 T.C. 349 (1998) (costs incurred by bank in originating loans were deductible); but see Strouth v. Comm'r, T.C. Memo 1987-552 (deduction denied for fees paid by partnership engaged in the business of leasing for leasing company's services in arranging leases).

⁹⁴ Compare Tech. Adv. Mem. 199952069 (Jan. 3, 2000) (costs for employee compensation, other employee benefits, and travel in connection with soliciting, evaluating, and negotiating 10-year professional and consulting service contracts required to be capitalized).

⁹⁵ See PNC Bancorp v. Comm'r, 212 F.3d 822 (3d Cir. 2000), rev'g 110 T.C. 349 (1998) (costs incurred by bank in originating loans were deductible; costs included: (i) payments made to third parties for activities that help the bank determine whether to approve a loan (credit screening, property reports, and appraisals) and for the recording of security interests when the bank decides to issue a secured loan and (ii) that portion of employee salaries and benefits that can be attributed to time spent completing and reviewing loan applications, and to other efforts connected with loan marketing and origination); but see Lychuk v. Comm'r, 116 T.C. No. 27 (2001) (taxpayer, who was in the business of acquiring and servicing installment contracts, was required to capitalize the portion of its employees' salaries that was directly related to the successful acquisition of installment contracts; the court "respectfully disagree[d]" with the PNC decision and held that the recurring nature of the expenses did not cause them to be deductible); Tech. Adv. Mem. 9024003 (Mar. 2, 1990) (a savings bank must capitalize amounts paid for credit reports, filing and recording fees, attorney fees, and other related closing costs incurred in processing home equity line- of-credit loans; because the loans are separate assets, the costs to create or acquire them are capitalizable and amortizable over the life of the loans); Rev. Rul. 57-400, 1957-2 CB 520 ("'Finders fees (buying commissions) paid by mutual savings banks, building and loan associations, cooperative banks and other classes of banks, to brokers, title companies, and other third parties for their introduction of acceptable applicants for mortgage loans, constitute a part of the acquisition cost of the loans which must be capitalized and amortized over the lives of the mortgage loans made to such applicants. See section 39.113(b)(1)-4(c) of Regulations 118, applicable under the Internal Revenue Code of 1954 by virtue of Treasury Decision 6091, C.B. 1954-2, 47, which, although referring specifically to mortgages purchased, acquired, or originated at a premium by mutual savings banks, building and loan associations, and cooperative banks, provides the foregoing rule with respect to the treatment of finders fees (buying commissions) that is deemed equally applicable to such fees paid in connection with mortgage loans originated by any class of bank."); Gen. Couns. Mem. 35681 (Feb. 19, 1974) (salaries, wages, office overhead and other similar expenses incurred in originating mortgage loans are currently deductible to the extent they are not directly related to the acquisition of a loan; those expenses that are directly connected with originating a mortgage will be treated as part of the cost of the mortgage and amortized over its life (i.e., when taxpayer pays one of its salesmen a commission for securing a mortgage loan, the commission must be capitalized over the life of the loan)).

⁹⁶ MRAS is modeled on the former ADR Repair Allowance System provided under section 1.167(a)-11(d)(2) of the regulations that generally was (and continues to be) available for property placed in service between 1971 and 1980. The proposed MRAS is tailored to the current Modified Accelerated Cost Recovery System (MACRS). The underlying intent of the new MRAS proposal is the same as the old system, which is to reduce disagreements between taxpayers and the IRS about whether a particular expenditure should be expensed or capitalized.

Under the ADR system, if the IRS had assigned a repair allowance percentage to an ADR asset class, the taxpayer could elect to have expenditures for "repair, maintenance, rehabilitation or improvement" of that class of assets characterized as currently deductible, to the extent the expenditures did not exceed the allowance for that class, with excess expenditures for that class capitalized as a new asset. Certain expenditures - defined as "excluded additions" - were excluded from the repair allowance, and were also capitalized as new assets. The election to use the repair allowance system was available on an annual basis, for assets in any asset class.

Specific authorization for the Repair Allowance System was provided by section 263(e), which was repealed, generally effective for assets placed in service after 1980, upon enactment of the Accelerated Cost Recovery System (ACRS) in 1981.

⁹⁷ As under the ADR system, no specific definition of "repair, maintenance, rehabilitation or improvement" of assets is included. The proposal does not intend to change the definition that applies under existing authorities.

⁹⁸ See, e.g., section 1011(a) ("The adjusted basis for determining the gain or loss from the sale or other disposition of property, whenever acquired, shall be the basis (determined under section 1012 or other applicable sections of this subchapter and subchapters C (relating to corporate distributions and adjustments), K (relating to partners and partnerships), and P (relating to capital gains and losses)), adjusted as provided in section 1016.").

⁹⁹ In general, leased property is assigned to a MACRS/ADR class based on its use by the lessee.

¹⁰⁰ This would include the type of expenditure that would be currently deductible under Rev. Rul. 94-38, 1994-1 C.B. 35.

¹⁰¹ See, e.g., Treas. Reg. section 1.167(a)-11(d)(3)(x).

¹⁰¹ See Treas. Reg. section 1.167(a)-11(d)(2)(vi).

¹⁰³ See Rev. Rul. 94-38, 1994-1 C.B. 35 (certain environmental remediation expenditures incurred by manufacturer deductible whether taxpayer continued manufacturing operations or discontinued operations and held land in idle state).

¹⁰⁴ See Tech. Adv. Mem. 199952075 (Aug. 28, 1999) (taxpayer planned to construct new building on contaminated site, remediation costs did not adapt site to new or different use, rather such costs merely restored site to condition that existed when taxpayer acquired property).

¹⁰⁵ See Treas. Reg. section 1.167(a)-11(d)(2)(vi).

¹⁰⁶ See Plainfield-Union Water Co. v. Comm'r, 39 T.C. 333 (1962) (replacement of tar lining in underground water pipes with cement lining did not materially increase value of pipes; "An expenditure which returns property to the state it was in before the situation prompting the expenditure arose, and which does not make the relevant property more valuable, more useful, or longer-lived, is usually deemed a deductible repair. A capital expenditure is generally considered to be a more permanent increment in the longevity, utility, or worth of the property."), nonacq. 1964-2 C.B. 8; see also Dominion Resources v. U.S., 219 F.3d 359, 2000-2 USTC P50, 633 (4th Cir. 2000) ("If the improvement only restores value to the property that existed prior to deterioration or to a discrete event that damaged the property, the improvement may be properly treated as a deductible repair expense."), aff'g 48 F. Supp. 2d 527 (E.D. VA. 1999); Priv. Ltr. Rul. 199903030 (Nov. 24, 1998) (deduction allowed for costs incurred to restore business properties to pre- flood state; determination of whether expenditure is currently deductible depends on comparison of life and value of repaired property to life and value of property before situation that prompted expenditure arose).

¹⁰⁷ See Rev. Rul. 95-74, 1995-2 C.B. 36 (parent corporation transferred contaminated land to subsidiary in section 351 transfer, subsidiary allowed section 162 deduction for environmental remediation expenditures because it is consistent with the congressional intent of section 351 for the transferee to step into the shoes of the transferor with respect to assumed liabilities).

¹⁰⁸ See Rev. Rul. 2001-4, 2001-3 I.R.B. 295, citing Badger Pipeline v. Comm'r, T.C.M. 1997-457 (costs to replace 1,000 feet of pipeline in a 25-mile section of pipeline were deductible repairs, regardless of whether the new pipe was of better quality or has a longer life).

¹⁰⁹ See Vanalco, Inc. v. Comm'r, T.C. Memo 1999-265 (expenditures to replace brick floors of aluminum reduction cell rooms with Fondag cement must be capitalized because the cement floors provided "substantial functional improvement" over brick and increased value of property by making repairs faster and more efficient).

¹¹⁰ See R. R. Hensler, Inc. v. Comm'r, 73 T.C. 168 (1979) (expenses incurred by reason of casualty deductible under section 162 if section 162 requirements satisfied; taxpayer may choose whether to deduct expense in year paid or incurred under section 162(a) or to deduct loss in the year loss sustained under section 165).

¹¹¹ See Rev. Rul. 94-38, 1994-1 C.B. 35 (deduction allowed under section 162 for costs incurred to clean up land and to treat groundwater that the taxpayer contaminated with hazardous waste from its business; expenditures merely restored the land to the state it was in before it was contaminated; costs of constructing groundwater treatment facilities were capitalized under section 263(a) and depreciated).

¹¹² See id.

¹¹³ See Rev. Rul. 98-25, 1998-1 C.B. 998 (costs of underground storage tanks (USTs) that are "filled with waste once, sealed indefinitely, and thereafter have no salvage value, . . . have no remaining useful life . . . and therefore are similar to a material or supply that is consumed and used in operation[s] during the taxable year" are deductible under section 162; "costs of removing, cleaning, and disposing of the old USTs, and filling and on-going monitoring of the new USTs are deductible as business expenses under section 162").

¹¹⁴ See Vanalco Inc. v. Comm'r, 78 T.C.M. (CCH) 251 (1999) (determination of whether expenditure was capital or currently deductible based in part on whether asset has longer life after expenditure than original estimated economic useful life; if life after expenditure continues to be shorter than original life, expenditure did not appreciably prolong asset's life); see also American Bemberg Corp. v. Comm'r, 10 T.C. 361 (1948) (taxpayer filled underground cavities with grout and cement to avert a cave-in of taxpayer's plant, deduction allowed because purpose of expenditure was not to improve, better, increase value or prolong original useful life).

¹¹⁵ See Treas. Reg. section 1.167(a)-1(b); see also Treas. Reg. section 1.167(a)-11(g)(1)(ii)(b) (for assets depreciated under CLADR, whether an expenditure prolongs life of asset for purposes of sections 162 and 263(a) "determined on the basis of the anticipated period of use of the asset (estimated at the close of the tax year in which the asset is first placed in service) without regard to the asset depreciation period for such asset").

In Rev. Rul. 2001-4, 2001-3 I.R.B. 295, the Service adopted the reasoning encompassed within this rule, stating with respect to Situations 1 and 2 that heavy maintenance expenditures on an aircraft's airframe "merely kept the airframe in an ordinarily efficient operating condition over its anticipated useful life for the uses for which the property was acquired." See also Ingram Industries, Inc. v. Comm'r, T.C.M. 2000-323.

¹¹⁶ See Rev. Rul. 2001-4, 2001-3 I.R.B. 295, citing Badger Pipeline v. Comm'r, T.C.M. 1997-457 (costs to replace 1,000 feet of pipeline in a 25-mile section of pipeline were deductible repairs, regardless of whether the new pipe was of better quality or has a longer life).

¹¹⁷ See American Bemberg Corp. v. Comm'r, 10 T.C. 361 (1948), aff'd per curiam, 177 F.2d 200 (6th Cir. 1949) (taxpayer capitalized cost of repairs to plant, seeking deduction only for cost of soil drilling and grout injection); see also Munroe Land Co. v. Comm'r, 25 T.C.M. (CCH) 3 (1966) (unexpected complication of adding addition resulted in condensation and water problem, deduction allowed for expenditures to stop leaks by adding insulation to outside of roof, expenditures were nearly half of roof cost and nearly 10% of cost of entire building; court notes that in prior cases deductions have been allowed for costs that "ordinarily might be treated as capital expenses, where no increase in the value and useful life of the property resulted, and where the purpose of the expenditure was to prevent the useful life of the repaired property from being shortened due to unusual circumstances").

¹¹⁸ See Buckland v. U.S., 66 F. Supp. 681 (D. Conn. 1946) (expenditures to repair windows, including replacing old concrete window sills after repairing, straightening, and painting steel sash, were deductible because substitutions were minor in proportion to physical structure of building and did not appreciably extend useful life of building even though expenditures constituted 35% of value of building).

¹¹⁹ See Jacks v. Comm'r, 55 T.C.M. (CCH) 968 (1988) (expenditures to replace all of major parts of CAT loader engine except engine block must be capitalized because, in lieu of simply repairing defect of engine, taxpayer essentially rebuilt engine and would receive benefits from rebuilding it over a number of years).

¹²⁰ See Priv. Ltr. Rul. 1999-03-030 (Nov. 24, 1998) (providing general advice about availability of casualty loss and repair deductions; ruling does not address effect of deducting casualty loss on amount of repair deduction).

¹²¹ See Oberman Manufacturing Co. v. Comm'r, 47 T.C. 471 (1967), acq. 1967-2 C.B. 2 (roof repair expenditures, including addition of roof expansion joint, insulation, and asphalt and gravel top, deductible because merely restored roof to leak-free state in which it had been for first two to three years that taxpayer owned property).

¹²² See Moss v. Comm'r, 831 F.2d 833 (9th Cir. 1987), rev'g 51 T.C.M. (CCH) 742 (1986) (taxpayer spent approximately $400,000 over two-year period to repair hotel; work included repainting and repapering of remodeled guestrooms and public areas, which had a three to five year economic useful life; hotels must continuously make repairs to keep property competitive and in first-class condition, plan of rehabilitation doctrine inapplicable); L&L Marine Service, Inc. v. Comm'r, 54 T.C.M. 567 (1958) (barges damaged due to harsh use; stringent certification standards applied; expenditures to replace worn-out parts of large asset, which were capitalized as part of cost of entire asset when first purchased, deductible if expenditures keep asset in operating condition; recurring repairs, although involving replacement parts, were incidental to normal operation of barges, kept barges in ordinarily efficient operating condition, did not materially add value or prolong lives as compared to value and life expectancy prior to use that necessitated repairs; expenditures deductible); Van Iderstine Co. v. Comm'r, 261 F.2d 211 (2nd Cir. 1958); Snow v. Comm'r, 31 T.C. 585 (1958); T.J. Enterprises, Inc. v. Comm'r, 101 T.C. 581 (1993).

¹²³ See Libby & Blouin, Ltd. v. Comm'r, 4 B.T.A. 910 (1926) (expenditures to replace copper tubes used to manufacture sugar were deductible because replacement tubes were small parts of large machine, merely kept large machine in "ordinary, efficient working condition," and did not add anything of value to machine beyond keeping it in "an efficient condition").

¹²⁴ See Rev. Rul. 2000-7, 2000-9 I.R.B. 712, which holds that removal costs are deductible when a depreciable asset is retired and removed, even though in connection with the installation or production of replacement assets, the costs of which must be capitalized. Rev. Rul. 2000-7 reasons that the costs of removing an asset have historically been allocable to the removed asset and, thus, are generally deductible.

¹²⁵ See Rev. Rul. 2001-4, 2001-3 I.R.B. 295.

¹²⁶ See United States v. Wehrli, 400 F.2d 686 (10th Cir. 1968).

¹²⁷ As a condition of maintaining its operating license and airworthiness certification for aircraft, X is required by the FAA to establish and adhere to a continuous maintenance program for each aircraft within its fleet. These programs, which are designed by X and the aircraft's manufacturer and approved by the FAA, are incorporated into each aircraft's maintenance manual. The maintenance manuals require a variety of periodic maintenance visits at various intervals during the operating lives of each aircraft. The most extensive of these for X is termed a "heavy maintenance visit" (also known in the industry as a "D check," "heavy C check," or "overhaul"), which is required to be performed by X approximately every eight years of aircraft operation. The purpose of a heavy maintenance visit, according to X's maintenance manual, is to prevent deterioration of the inherent safety and reliability levels of the aircraft equipment and, if such deterioration occurs, to restore the equipment to their inherent levels.

To perform a heavy maintenance visit, X extensively disassembles the airframe, removing items such as its engines, landing gear, cabin and passenger compartment seats, side and ceiling panels, baggage stowage bins, galleys, lavatories, floorboards, cargo loading systems, and flight control surfaces. As specified by X's maintenance manual, X performs certain tasks on the disassembled airframe for the purpose of preventing deterioration of the inherent safety and reliability levels of the airframe. These tasks included lubrication and service; operational and visual checks; inspection and functional checks; restoration of minor parts and components; and removal, discard, and replacement of certain life-limited single cell parts, such as cartridges, canisters, cylinders, and disks.

Whenever the execution of a task revealed cracks, corrosion, excessive wear, or dysfunctional operation, X is required by the maintenance manual to restore the airframe to an acceptable condition. This restoration involved burnishing corrosion; repairing cracks, dents, gouges, punctures, or scratches by burnishing, blending, stop-drilling, or applying skin patches or doublers over the affected area; tightening or replacing loose or missing fasteners, rivets, screws, bolts, nuts, or clamps; repairing or replacing torn or damaged seals, gaskets, or valves; repairing or replacing damaged or missing placards, decals, labels, or stencils; additional cleaning, lubricating, or painting; further inspecting or testing, including the use of sophisticated non-destructive inspection methods; repairing fiberglass or laminated parts; replacing bushings, bearings, hinges, handles, switches, gauges, or indicators; repairing chaffed or damaged wiring; repairing or adjusting various landing gear or flight surface control cables; replacing light bulbs, window panes, lenses, or shields; replacing anti-skid materials and stops on floors, pedals, and stairways; replacing floor boards; and performing minor repairs on ribs, spars, frames, longerons, stringers, beams, and supports.

¹²⁸ See Rev. Rul. 2001-4, 2001-3 I.R.B. 295.

¹²⁹ See Ingram Industries, Inc. v. Comm'r, T.C.M. 2000-323.