Bulletin No. 2004-7February 17, 2004

HIGHLIGHTSOF THIS ISSUEThese synopses are intended only as aids to the reader inidentifying the subject matter covered. They may not berelied upon as authoritative interpretations.

INCOME TAX

Rev. Rul. 2004–3, page 486.Service partnerships. This ruling provides guidance con-cerning the application of the U.S.-Germany income tax treatyto a nonresident partner in a service partnership that conductsactivities in the United States. It makes clear that a nonresi-dent partner is subject to U.S. income tax on his share of in-come from the partnership to the extent that such income isattributable to the partnership’s activities in the United States,without regard to whether the partner performs services in theUnited States. This ruling also applies to other U.S. income taxtreaties that have the same or similar provisions as those in theU.S.-Germany treaty.

T.D. 9107, page 447.Final regulations under section 263(a) of the Code provide rulesfor applying section 263(a) to amounts paid to acquire or cre-ate intangibles. These regulations also provide rules for apply-ing section 263(a) to amounts paid to facilitate the acquisitionof a trade or business, a change in the capital structure ofa business entity, and certain other transactions. In addition,these regulations provide safe harbor amortization under sec-tion 167(a) for certain intangibles and explain the manner inwhich taxpayers may deduct debt issuance costs.

Notice 2004–5, page 489.Pursuant to the authority granted under section 772(a)(11) ofthe Code, the Secretary has determined that it is appropriatefor a partner of an electing large partnership to take into ac-count separately the partner’s distributive share of the partner-ship’s dividends received that are qualified dividend income asdefined in section 1(h)(11)(B). This requirement is effective fordividends received by a partnership after December 31, 2002.

EMPLOYEE PLANS

Rev. Rul. 2004–10, page 484.Significant detriment; defined contribution plan; al-location of expenses. This ruling describes the applica-tion of the significant detriment rule in regulations section1.411(a)–11(c)(2)(i) in relationship to the Department ofLabor’s Field Assistance Bulletin 2003–3 pertaining to theallocation of expenses in a defined contribution plan.

Rev. Rul. 2004–11, page 480.Coverage; special rules; request for comments. Thisruling describes the application of the special coverage rulefor acquisitions and dispositions in section 410(b)(6)(C) of theCode in a situation involving a defined benefit plan and a profit-sharing plan that includes a qualified cash or deferred arrange-ment under section 401(k)(2). In addition, the ruling holds thata significant change in a plan or in the coverage of a plan duringthe transition period under section 410(b)(6)(C)(ii) curtails theperiod effective as of the date of the change and does not makethe plan retroactively ineligible to apply section 410(b)(6)(C). Fi-nally, the ruling also asks for comments as to other situationsthat may arise under section 410(b)(6)(C).

Rev. Rul. 2004–12, page 478.Plan qualification; rollovers. This ruling describes a situa-tion where an eligible retirement plan separately accounts foramounts attributable to rollover contributions to the plan. Asa result, distributions of those amounts are not subject to therestrictions on permissible timing that apply, under the applica-ble requirements of the Code, to distributions of other amountsfrom the plan.

(Continued on the next page)

Announcements of Disbarments and Suspensions begin on page 499.Finding Lists begin on page ii.

Rev. Rul. 2004–13, page 485.Top-heavy status; special rules. This ruling describes foursituations where a non-governmental profit-sharing plan con-tains a cash or deferred arrangement described in section401(k) of the Code that provides for safe harbor matching con-tributions. In the first situation, the ruling holds that the require-ments of section 416(g)(4)(H) are met for that year. In the othersituations, the ruling holds that the contributions do not meetthe requirements of section 416(g)(4)(H).

Rev. Proc. 2004–14, page 489.This document provides procedures under which a corpora-tion’s S status will not be terminated by a direct rollover of stockfrom its employee stock ownership plan (ESOP) to a partici-pant’s individual retirement account (IRA). Rev. Proc. 2003–23modified and superseded.

Rev. Proc. 2004–15, page 490.Minimum funding standards; waivers. This procedure setsforth guidelines for requesting waivers of the minimum fundingstandards with respect to defined benefit and defined contri-bution plans subject to section 412 of the Code. Rev. Procs.2004–4, 2004–5, 2004–6 modified. Rev. Proc. 94–41 su-perseded.

TAX CONVENTIONS

Rev. Rul. 2004–3, page 486.Service partnerships. This ruling provides guidance con-cerning the application of the U.S.-Germany income tax treatyto a nonresident partner in a service partnership that conductsactivities in the United States. It makes clear that a nonresi-dent partner is subject to U.S. income tax on his share of in-come from the partnership to the extent that such income isattributable to the partnership’s activities in the United States,without regard to whether the partner performs services in theUnited States. This ruling also applies to other U.S. income taxtreaties that have the same or similar provisions as those in theU.S.-Germany treaty.

ADMINISTRATIVE

Rev. Proc. 2004–14, page 489.This document provides procedures under which a corpora-tion’s S status will not be terminated by a direct rollover of stockfrom its employee stock ownership plan (ESOP) to a partici-pant’s individual retirement account (IRA). Rev. Proc. 2003–23modified and superseded.

Announcement 2004–10, page 501.This document contains corrections to final and temporary reg-ulations (T.D. 9048, 2003–1 C.B. 644) under section 1502 ofthe Code that redetermine the basis of stock of a subsidiarymember of a consolidated group immediately prior to certaintransfers of such stock and certain deconsolidations of a sub-sidiary member and also suspend certain losses recognizedon the disposition of stock of a subsidiary member.

February 17, 2004 2004-7 I.R.B.

The IRS MissionProvide America’s taxpayers top quality service by helpingthem understand and meet their tax responsibilities and by

applying the tax law with integrity and fairness to all.

IntroductionThe Internal Revenue Bulletin is the authoritative instrument ofthe Commissioner of Internal Revenue for announcing officialrulings and procedures of the Internal Revenue Service and forpublishing Treasury Decisions, Executive Orders, Tax Conven-tions, legislation, court decisions, and other items of generalinterest. It is published weekly and may be obtained from theSuperintendent of Documents on a subscription basis. Bul-letin contents are consolidated semiannually into CumulativeBulletins, which are sold on a single-copy basis.

It is the policy of the Service to publish in the Bulletin all sub-stantive rulings necessary to promote a uniform application ofthe tax laws, including all rulings that supersede, revoke, mod-ify, or amend any of those previously published in the Bulletin.All published rulings apply retroactively unless otherwise indi-cated. Procedures relating solely to matters of internal man-agement are not published; however, statements of internalpractices and procedures that affect the rights and duties oftaxpayers are published.

Revenue rulings represent the conclusions of the Service on theapplication of the law to the pivotal facts stated in the revenueruling. In those based on positions taken in rulings to taxpayersor technical advice to Service field offices, identifying detailsand information of a confidential nature are deleted to preventunwarranted invasions of privacy and to comply with statutoryrequirements.

Rulings and procedures reported in the Bulletin do not have theforce and effect of Treasury Department Regulations, but theymay be used as precedents. Unpublished rulings will not berelied on, used, or cited as precedents by Service personnel inthe disposition of other cases. In applying published rulings andprocedures, the effect of subsequent legislation, regulations,

court decisions, rulings, and procedures must be considered,and Service personnel and others concerned are cautionedagainst reaching the same conclusions in other cases unlessthe facts and circumstances are substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.This part includes rulings and decisions based on provisions ofthe Internal Revenue Code of 1986.

Part II.—Treaties and Tax Legislation.This part is divided into two subparts as follows: Subpart A,Tax Conventions and Other Related Items, and Subpart B, Leg-islation and Related Committee Reports.

Part III.—Administrative, Procedural, and Miscellaneous.To the extent practicable, pertinent cross references to thesesubjects are contained in the other Parts and Subparts. Alsoincluded in this part are Bank Secrecy Act Administrative Rul-ings. Bank Secrecy Act Administrative Rulings are issued bythe Department of the Treasury’s Office of the Assistant Sec-retary (Enforcement).

Part IV.—Items of General Interest.This part includes notices of proposed rulemakings, disbar-ment and suspension lists, and announcements.

The last Bulletin for each month includes a cumulative indexfor the matters published during the preceding months. Thesemonthly indexes are cumulated on a semiannual basis, and arepublished in the last Bulletin of each semiannual period.*

The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.

For sale by the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402.

* Beginning with Internal Revenue Bulletin 2003–43, we are publishing the index at the end of the month, rather than at the beginning.

2004-7 I.R.B. February 17, 2004

Part I. Rulings and Decisions Under the Internal Revenue Codeof 1986Section 263.—CapitalExpenditures26 CFR 1.263(a)–1: Capital expenditures; in gen-eral.

T.D. 9107

DEPARTMENT OFTHE TREASURYInternal Revenue Service26 CFR Parts 1 and 602

Guidance RegardingDeduction and Capitalizationof Expenditures

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document containsfinal regulations that explain how sec-tion 263(a) of the Internal Revenue Code(Code) applies to amounts paid to acquireor create intangibles. This document alsocontains final regulations under section167 of the Code that provide safe harboramortization for certain intangibles, andfinal regulations under section 446 of theCode that explain the manner in whichtaxpayers may deduct debt issuance costs.

DATES: Effective Date: These regulationsare effective December 31, 2003.

Applicability Date: For dates ofapplicability of the final regulations,see §§1.167(a)–3(b)(4), 1.263(a)–4(o),1.263(a)–5(m), and 1.446–5(d).

FOR FURTHER INFORMATIONCONTACT: Andrew J. Keyso, (202)622–4800 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information in this fi-nal rule has been reviewed and, pending re-ceipt and evaluation of public comments,approved by the Office of Managementand Budget (OMB) under 44 U.S.C. 3507and assigned control number 1545–1870.

The collection of information in thisregulation is in §1.263(a)–5(f). This in-formation is required to verify the properallocation of certain amounts paid in theprocess of investigating or otherwise pur-suing certain transactions involving the ac-quisition of a trade or business. The col-lection of information is voluntary and isrequired to obtain a benefit. The likelyrecordkeepers are business entities.

Comments on the collection of infor-mation should be sent to the Office ofManagement and Budget, Attn: DeskOfficer for the Department of the Trea-sury, Office of Information and Regula-tory Affairs, Washington, DC 20503, withcopies to the Internal Revenue Service,Attn: IRS Reports Clearance Officer,SE:W:CAR:MP:T:T:SP, Washington, DC20224. Comments on the collection ofinformation should be received by March5, 2004. Comments are specifically re-quested concerning:

Whether the collection of informationis necessary for the proper performanceof the functions of the Internal RevenueService, including whether the informationwill have practical utility;

The accuracy of the estimated burdenassociated with the collection of informa-tion (see below);

How the quality, utility, and clarity ofthe information to be collected may be en-hanced;

How the burden of complying with thecollection of information may be mini-mized, including through the applicationof automated collection techniques orother forms of information technology;and

Estimates of capital or start-up costsand costs of operation, maintenance, andpurchase of service to provide information.

Estimated total annual recordkeepingburden: 3,000 hours.

Estimated average annual burden hoursper recordkeeper: 1 hour.

Estimated number of recordkeepers:3,000.

An agency may not conduct or sponsor,and a person is not required to respond to, acollection of information unless it displaysa valid control number assigned by the Of-fice of Management and Budget.

Books or records relating to a collectionof information must be retained as longas their contents may become material inthe administration of any internal revenuelaw. Generally, tax returns and tax returninformation are confidential, as requiredby 26 U.S.C. 6103.

Background

On January 24, 2002, the IRS andTreasury Department published an ad-vance notice of proposed rulemaking inthe Federal Register (REG–125638–01,published in the Bulletin as Announce-ment 2002–9, 2002–1 C.B. 536 [67 FR3461]) announcing an intention to pro-vide guidance on the extent to whichsection 263(a) of the Internal RevenueCode (Code) requires taxpayers to cap-italize amounts paid to acquire, create,or enhance intangible assets. A noticeof proposed rulemaking was published inthe Federal Register (REG–125638–01,2003–1 C.B. 373 [67 FR 77701]) onDecember 19, 2002, proposing regula-tions under section 263(a) (relating to thecapitalization requirement), section 167(relating to safe harbor amortization) andsection 446 (relating to the allocation ofdebt issuance costs). A public hearingwas held on April 22, 2003. In addition,written comments responding to the noticeof proposed rulemaking were received.After consideration of all of the publiccomments, the proposed regulations areadopted as revised by this Treasury deci-sion. The revisions are discussed below.

Explanation of Provisions

I. Format of the Final Regulations

The final regulations modify the formatof the proposed regulations. The final reg-ulations retain in §1.263(a)–4 the rules re-quiring capitalization of amounts paid toacquire or create intangibles and amountspaid to facilitate the acquisition or creationof intangibles. However, the rules requir-ing capitalization of amounts paid to facil-itate an acquisition of a trade or business, achange in the capital structure of a businessentity, and certain other transactions arecontained in a new §1.263(a)–5. Dividing

2004-7 I.R.B. 447 February 17, 2004

the rules into two sections enabled the IRSand Treasury Department to apply someof the simplifying conventions in the pro-posed regulations to certain acquisitionsof tangible assets in §1.263(a)–5, whilelimiting the application of §1.263(a)–4 tocosts of acquiring and creating intangibles.The format of the final regulations con-tained in §§1.446–5 and 1.167(a)–3 is es-sentially unchanged from the format of theproposed version of these regulations.

II. Explanation and Summary ofComments Concerning §1.263(a)–4

A. General principle of capitalization

The final regulations identify cate-gories of intangibles for which capital-ization is required. As in the proposedregulations, the final regulations providethat an amount paid to acquire or createan intangible not otherwise required tobe capitalized by the regulations is notrequired to be capitalized on the groundthat it produces significant future benefitsfor the taxpayer, unless the IRS pub-lishes guidance requiring capitalizationof the expenditure. If the IRS publishesguidance requiring capitalization of anexpenditure that produces future benefitsfor the taxpayer, such guidance will applyprospectively. While most commentatorssupport this approach, some commenta-tors expressed concerns that this approach,particularly the prospective nature of fu-ture guidance, will permit taxpayers todeduct expenditures that should properlybe capitalized. The IRS and TreasuryDepartment continue to believe that thecapitalization principles in the regulationsstrike an appropriate balance between thecapitalization provisions of the Code andthe ability of taxpayers and IRS personnelto administer the law, and are a reasonablemeans of enforcing the requirements ofsection 263(a).

The final regulations change the gen-eral principle of capitalization in threerespects from the proposed regulations.First, §1.263(a)–4 of the final regulationsdoes not include the rule requiring cap-italization of amounts paid to facilitatea “restructuring or reorganization of abusiness entity or a transaction involv-ing the acquisition of capital, including astock issuance, borrowing, or recapitaliza-tion.” As noted above, the rules requiring

taxpayers to capitalize amounts paid tofacilitate these types of transactions arenow contained in §1.263(a)–5.

Second, the final regulations elimi-nate the word “enhance” from portionsof the general principle. Commentatorsexpressed concerns that the use of the term“enhance” would require capitalization inunintended circumstances. For example, ifa taxpayer acquires goodwill as part of theacquisition of a trade or business, futureexpenditures to maintain the reputationof the trade or business arguably couldconstitute amounts paid to “enhance” theacquired goodwill. The final regulationsremove the word “enhance” in favor ofmore specifically identifying the types ofenhancement for which capitalization isappropriate. For example, the final reg-ulations modify the proposed regulationsto provide that a taxpayer must capitalizean amount paid to “upgrade” its rightsunder a membership or a right granted bya government agency.

Third, the final regulations eliminatethe use of, and the definition of, the term“intangible asset” that was contained in theproposed regulations. This change wasmade in an effort to aid readability. The fi-nal regulations simply identify categoriesof “intangibles” for which amounts are re-quired to be capitalized.

The final regulations clarify that noth-ing in §1.263(a)–4 changes the treatmentof an amount that is specifically providedfor under any other provision of the Code(other than section 162(a) or 212) or reg-ulations thereunder. Thus, where anothersection of the Code (or regulations un-der that section) prescribes a specific treat-ment of an amount, the provisions of thatsection apply and not the rules containedin these final regulations. For example,where the treatment of an insurance com-pany’s policy acquisition expenses is pre-scribed by sections 848 and 197(f)(5) ofthe Code, those sections apply and notthese final regulations. Similarly, capital-ization is not required under the final regu-lations for expenditures that are deductibleunder section 174.

The general definition of a separate anddistinct intangible asset in paragraph (b)(3)of the final regulations is unchanged fromthe proposed regulations, except to clarifythat a separate and distinct intangible assetmust be intrinsically capable of being sold,transferred, or pledged (ignoring any re-

strictions imposed on assignability) sepa-rate and apart from a trade or business. Thefinal regulations also clarify that a fund istreated as a separate and distinct intangibleasset of the taxpayer if amounts in the fundmay revert to the taxpayer.

In addition, the application of the sep-arate and distinct intangible asset defini-tion to specific intangibles has been furtherlimited in the final regulations. The finalregulations provide that an amount paidto create a package design, computer soft-ware or an income stream from the perfor-mance of services under a contract is nottreated as an amount that creates a separateand distinct intangible asset. For a furtherdiscussion of issues pertaining to computersoftware, see the discussion in Part II.H.of this Preamble titled “Computer softwareissues.” In addition, examples are addedto paragraph (l) of the final regulations toclarify that product launch costs and stock-lifting costs do not create a separate anddistinct intangible asset.

B. Clear reflection of income

Commentators questioned how the reg-ulations interact with the clear reflection ofincome requirement of section 446(b) andwhether the IRS would argue that an ex-penditure that is not required to be capi-talized by the regulations should nonethe-less be capitalized on the ground that de-duction of the expenditure does not clearlyreflect income under section 446. If anamount paid to acquire or create an intan-gible is not required to be capitalized byanother provision of the Code or regula-tions thereunder or by the final regulationsor in subsequent published guidance, theIRS will not argue that the clear reflectionof income requirement of section 446(b)and the regulations thereunder necessitatescapitalization.

C. Intangibles acquired from another

The final regulations retain the require-ment of the proposed regulations that a tax-payer must capitalize amounts paid to an-other party to acquire any intangible fromthat party in a purchase or similar transac-tion. Like the proposed regulations, the fi-nal regulations provide a nonexclusive listof intangibles for which capitalization isrequired. To further clarify that the listis illustrative, the final regulations modifythe introductory language to specifically

February 17, 2004 448 2004-7 I.R.B.

state that the list contains “examples” ofintangibles within the scope of paragraph(c).

D. Created intangibles

1. In General

The final regulations retain the eightcategories of created intangibles containedin the proposed regulations. As discussedabove, the final regulations eliminate theterm “enhance” from the general princi-ple. Instead, as described below, severalof the categories of created intangibles arerevised to more specifically identify thetypes of enhancements for which capital-ization is required.

A commentator noted that the approachadopted in the regulations of defining cat-egories of intangibles may be subject toabuse if taxpayers seek to deduct expen-ditures based on immaterial distinctionsbetween those expenditures and expendi-tures included in the listed categories. Toaddress this concern, the final regulationscontain a rule providing that the determi-nation of whether an amount is paid to cre-ate an intangible identified in the final reg-ulations is made based on all of the factsand circumstances, disregarding distinc-tions between the labels used in the reg-ulations to describe the intangible and thelabels used by the taxpayer and other par-ties to describe the transaction. The IRSand Treasury Department intend to con-strue broadly the categories of intangiblesidentified in the regulations in responseto any narrow technical arguments that anintangible created by the taxpayer is notliterally described in the categories. Forexample, a taxpayer that obtains what is,in substance, a membership in an organ-ization cannot avoid capitalization underparagraph (d)(4) of the final regulations byarguing that the right is titled an “admis-sion” or that the right explicitly providesthe taxpayer a “participation right” but nota membership.

2. Financial Interests

The final regulations require taxpayersto capitalize an amount paid to anotherparty to create, originate, enter into, re-new or renegotiate with that party certainfinancial interests. The final regulationsretain the categories of financial interests

contained in the proposed regulations, withminor modifications.

The final regulations eliminate the rulecontained in paragraph (d)(2)(ii) of theproposed regulations providing that cap-italization is not required for an amountpaid to create or originate an option orforward contract if the amount is alloca-ble to property required to be provided oracquired by the taxpayer prior to the endof the taxable year in which the amount ispaid. This rule was unnecessary and wasincorrectly read by some commentators tosuggest that taxpayers could immediatelydeduct amounts paid to create or originatean option or forward contract. The finalregulations clarify the treatment of theseamounts.

3. Prepaid Expenses

The final regulations retain the rule con-tained in the proposed regulations. Thereference to “benefits to be received in thefuture” has been deleted to avoid any im-plication of a “significant future benefits”test. No comments were received suggest-ing changes to the rule.

4. Certain Memberships and Privileges

The final regulations retain the rulecontained in the proposed regulations, butclarify that capitalization also is requiredif a taxpayer renegotiates or upgrades amembership or privilege. The final regula-tions also modify an example contained inthe proposed regulations that does not ad-dress the implications of section 274(a)(3)and unintentionally implies that an amountpaid to obtain membership in a social clubis required to be capitalized under the reg-ulations. The revised example addressesan amount paid to obtain a membership ina trade association.

5. Certain Rights Obtained From aGovernmental Agency

The final regulations retain the rulecontained in the proposed regulations, butclarify that capitalization also is requiredif a taxpayer renegotiates or upgrades itsrights. For example, a holder of a businesslicense that pays an amount to upgrade itslicense, enabling it to sell additional typesof products or services, must capitalizethat amount.

Several commentators questionedwhether an amount paid to a governmentagency to obtain a patent from that agencyis required to be capitalized under thisrule if section 174 applies to the amount.As previously discussed, the regulationsdo not affect the treatment of an expendi-ture under other provisions of the Code.Accordingly, an amount paid to a govern-ment agency to obtain a patent from thatagency is not required to be capitalizedunder the final regulations if the amount isdeductible under section 174.

6. Certain Contract Rights

The final regulations retain the rulescontained in the proposed regulations re-garding capitalization of amounts paid toenter into certain agreements. In addition,the final regulations clarify that taxpayersmust capitalize amounts paid to anotherparty to create, originate, enter into, renew,or renegotiate with that party an agreementnot to acquire additional ownership inter-ests in the taxpayer (i.e., a standstill agree-ment). The IRS and Treasury Departmentbelieve that the benefits obtained by thetaxpayer from a standstill agreement aresimilar to the benefits that result from otheragreements identified in the rule and thatcapitalization is therefore appropriate. Therule does not apply to a standstill agree-ment governed by another provision of theCode, such as section 162(k). An exam-ple has been added to the final regulationsto illustrate the application of this rule.The final regulations also clarify that a tax-payer must capitalize costs that facilitatethe creation of an annuity, endowment con-tract or insurance contract that does nothave or provide for cash value (e.g., a com-prehensive liability policy or a propertyand casualty policy) if the taxpayer is thecovered party under the contract.

The final regulations add three rules toaddress public comments that capitaliza-tion is not appropriate if the taxpayer hasonly a hope or expectation that a customeror supplier will begin or continue a busi-ness relationship with the taxpayer. First,the final regulations provide that amountspaid with the mere hope or expectation ofdeveloping or maintaining a business re-lationship are not required to be capital-ized, provided the amount is not contingenton the origination, renewal or renegotia-tion of an agreement. The IRS and Trea-

2004-7 I.R.B. 449 February 17, 2004

sury Department believe that amounts thatare contingent on the origination, renewalor renegotiation of an agreement are prop-erly capitalized as amounts paid to origi-nate, renew or renegotiate the agreement.Second, the final regulations provide thatan agreement does not provide a “right” toprovide services if the agreement merelyprovides that the taxpayer will stand readyto provide services if requested, but placesno obligation on another party to request orpay for the taxpayer’s services. Third, thefinal regulations provide that an agreementthat may be terminated at will by the otherparty (or parties) to the agreement prior tothe expiration of the period prescribed bythe “12-month rule” does not constitute anagreement providing the taxpayer the rightto use property or provide (or receive) ser-vices. However, where the other party (orparties) to the agreement is economicallycompelled not to terminate the agreementprior to the expiration of the period pre-scribed by the “12-month rule” in the reg-ulations, then the agreement is not consid-ered to be an agreement that may be termi-nated at will. Several examples are addedto the final regulations to illustrate the ap-plication of these rules.

The final regulations also clarify themeaning of “renegotiate.” Under the fi-nal regulations, a taxpayer is treated asrenegotiating an agreement if the termsof the agreement are modified. In addi-tion, a taxpayer is treated as renegotiatingan agreement if the taxpayer enters intoa new agreement with the same party (orsubstantially the same parties) to a termi-nated agreement, the taxpayer could notcancel the terminated agreement withoutthe agreement of the other party (or par-ties), and the other party (or parties) wouldnot have agreed to the cancellation unlessthe taxpayer entered into the new agree-ment. See U.S. Bancorp v. Commissioner,111 T.C. 231 (1998).

The final regulations retain the $5,000de minimis rule contained in the proposedregulations. In addition, the final regula-tions provide that, if an amount is paid inthe form of property, the property is val-ued at its fair market value at the timeof the payment for purposes of determin-ing whether the de minimis rule applies.The final regulations also retain the pool-ing method for de minimis costs of creat-ing similar agreements. See Part II.G. ofthis Preamble titled “Safe harbor pooling

methods” for a further explanation of rulespertaining to pooling.

7. Certain Contract Terminations

The final regulations retain the rulecontained in the proposed regulations.No comments were received suggestingchanges to the rule. The final regula-tions, however, clarify that the contracttermination provisions do not apply toamounts paid to terminate a transactionsubject to §1.263(a)–5. See Part III of thisPreamble (“Explanation and Summary ofComments Concerning §1.263(a)–5”) fora discussion of the treatment of amountspaid to terminate a transaction describedin §1.263(a)–5.

8. Benefits Arising From the Provision,Production, or Improvement of RealProperty

The final regulations retain the rulecontained in the proposed regulations, butclarify that the exceptions to the rule applyonly to the extent the taxpayer receivesfair market value consideration for the realproperty.

9. Defense or Perfection of Title toIntangible Property

The final regulations retain the rulecontained in the proposed regulations.No comments were received suggestingchanges to the rule. The final regulationsclarify that amounts paid to another partyto terminate an agreement permitting thatparty to purchase the taxpayer’s intangi-ble property or to terminate a transactiondescribed in §1.263(a)–5 are not treatedas amounts paid to defend or perfect title.See Part III of this Preamble (“Explanationand Summary of Comments Concerning§1.263(a)–5”) for a discussion of thetreatment of amounts paid to terminate atransaction described in §1.263(a)–5.

E. Transaction costs

1. In General

The final regulations require taxpayersto capitalize amounts that facilitate theacquisition or creation of an intangible.The proposed regulations provide that anamount facilitates a transaction if it ispaid “in the process of pursuing the trans-action.” Some commentators questioned

whether amounts paid to investigate atransaction constitute amounts paid in theprocess of pursuing the transaction. TheIRS and Treasury Department believe thatit is inappropriate to distinguish amountspaid to investigate the acquisition or cre-ation of an intangible from other amountspaid in the process of acquiring or creatingan intangible. To clarify that investiga-tory costs are within the scope of the rule,the final regulations provide that amountsfacilitate a transaction if they are paid inthe process of “investigating or otherwisepursuing the transaction.” In addition, thefinal regulations clarify that an amountpaid to determine the value or price of anintangible is an amount paid in the processof investigating or otherwise pursuing thetransaction.

The proposed regulations provide that,in determining whether an amount is paidto facilitate a transaction, the fact that theamount would (or would not) have beenpaid “but for” the transaction is “not rel-evant.” The IRS and Treasury Departmentbelieve that the fact that the amount wouldor would not have been paid “but for” thetransaction is a relevant factor, but not theonly factor, to be considered. Accordingly,the final regulations revise this rule to pro-vide that the fact that the amount would (orwould not) have been paid “but for” thetransaction is a relevant but not a “deter-minative” factor.

The final regulations eliminate the rulein the proposed regulations that treatsamounts paid to terminate (or facilitatethe termination of) an existing agreementas facilitating another transaction that isexpressly conditioned on the terminationof the agreement. The IRS and TreasuryDepartment decided that well advised tax-payers could easily avoid the rule by usinggeneral representations, while uninformedtaxpayers inadvertently could be caughtby the rule. The IRS and the TreasuryDepartment considered replacing the “ex-pressly conditioned” rule with a “mutuallyexclusive” rule similar to the one con-tained in §1.263(a)–5 (see Part III of thisPreamble). A mutually exclusive rule wasnot adopted in §1.263(a)–4 because such arule could have been interpreted as requir-ing capitalization of contract terminationcosts that historically have been deductible(for example, an amount paid to terminatea burdensome supply contract if the tax-payer enters into a new supply contract

February 17, 2004 450 2004-7 I.R.B.

(for which capitalization is required underthe regulations) with another party if thetaxpayer could not contract with both par-ties). A mutually exclusive rule also wasnot adopted in the final regulations be-cause it would have been administrativelydifficult to apply such a rule in the contextof ordinary business transactions. Instead,§1.263(a)–4 of the final regulations pro-vides that an amount paid to terminate (orfacilitate the termination of) an existingagreement does not facilitate the acquisi-tion or creation of another agreement.

Commentators expressed concern thatthe rules in the proposed regulations re-quiring taxpayers to capitalize amountspaid in the process of pursuing certainagreements could be interpreted verybroadly to require taxpayers to capitalizeamounts that should be treated as de-ductible costs of sustaining or expandingthe taxpayer’s business. To address thisconcern, the final regulations add a ruleproviding that an amount is treated as notpaid in the process of investigating or oth-erwise pursuing the creation of a contractright if the amount relates to activities per-formed before the earlier of the date thetaxpayer begins preparing its bid for thecontract or the date the taxpayer beginsdiscussing or negotiating the contract withanother party to the contract. An exampleis provided in the final regulations illus-trating the application of the rule.

2. Simplifying Conventions

The final regulations retain the simpli-fying conventions applicable to employeecompensation, overhead, and de minimiscosts, with several modifications.

For example, the final regulationstreat as employee compensation certainamounts paid to persons who may not beemployees of the taxpayer under section3401(c). Specifically, the final regulationsprovide that a guaranteed payment to apartner in a partnership is treated as em-ployee compensation. In addition, annualcompensation paid to a director of a cor-poration is treated as employee compen-sation. The final regulations also providethat, in the case of an affiliated group ofcorporations filing a consolidated federalincome tax return, a payment by one mem-ber of the group to a second member ofthe group for services performed by anemployee of the second member is treated

as employee compensation if the servicesare performed at a time during which bothmembers are affiliated. Other than thisrule for entities joining in a consolidatedreturn, the final regulations do not treatemployees of one entity as employees ofa related entity. The limited exception ismade for entities joining in a consolidatedreturn because these entities are appro-priately viewed as a single taxpayer forpurposes of the employee compensationsimplifying convention. The IRS andTreasury Department believe that whenother related entities provide services toeach other, they generally will maintainrecords of the time charged and will not besubject to undue recordkeeping burdens asa result of section 263(a).

Several commentators suggested thatthe simplifying convention for employeecompensation should apply to amountspaid to independent contractors who arenot hired specifically to facilitate a capitaltransaction. For example, many compa-nies hire outside contractors to provideadministrative and secretarial services,and these contractors work on a varietyof transactions, only some of which maybe capital. The final regulations extendthe employee compensation simplifyingconvention to amounts paid to outsidecontractors for secretarial, clerical, andsimilar administrative services.

The final regulations retain the $5,000de minimis threshold contained in the pro-posed regulations. Some commentatorssuggested that the threshold be a higheramount, or at least be indexed for inflation.The final regulations do not adopt thesesuggestions, but provide that the IRS mayprescribe a higher threshold amount in fu-ture published guidance. The final regula-tions also provide that, for purposes of de-termining whether a transaction cost paidin the form of property is de minimis, theproperty is valued at its fair market valueat the time of the payment. The final reg-ulations also retain the pooling method forde minimis transaction costs. See Part II.G.of this Preamble titled “Safe harbor pool-ing methods” for a further explanation ofthe rules relating to pooling.

The final regulations permit taxpayersto elect to capitalize employee compen-sation, overhead, or de minimis costs.Several commentators noted that taxpay-ers may capitalize such costs for financialaccounting purposes, and it may be dif-

ficult to segregate these costs for federalincome tax purposes. The final regulationspermit taxpayers to make this capitaliza-tion election with regard to any or all ofthe three categories of costs covered by thesimplifying conventions (i.e., employeecompensation, overhead, or de minimiscosts).

F. 12-month rule

The regulations retain the 12-monthrule contained in the proposed regulations.Under the 12-month rule, a taxpayer isnot required to capitalize amounts paid tocreate (or facilitate the creation of) certainrights or benefits with a brief duration.Some commentators suggested that thefirst prong of the measuring period shouldbe deleted, resulting in a rule that con-siders only whether the benefit extendsbeyond the end of the taxable year fol-lowing the year in which the payment ismade. The final regulations do not adoptthis suggestion. The IRS and Treasurycontinue to believe that the rule containedin the proposed regulations is sufficient toease the recordkeeping burden for trans-actions of relatively brief duration.

The final regulations clarify that ifa taxpayer is permitted to terminate anagreement described in this rule after anotice period, in determining whether the“12 month rule” applies, amounts paid toterminate the agreement before the end ofthe notice period create a benefit for thetaxpayer that lasts for the amount of timeby which the notice period is shortened.

The final regulations permit taxpayersto elect not to apply the 12-month rule tocategories of similar transactions. The IRSand Treasury Department recognize thatsome taxpayers may capitalize amountsfor financial accounting purposes thatwould not be required to be capitalizedfor federal income tax purposes due tothe 12-month rule. In some cases, it maybe difficult for taxpayers to identify andcalculate these amounts for purposes ofapplying the 12-month rule. For this rea-son, the final regulations permit taxpayersto elect to capitalize these amounts not-withstanding that the 12-month rule wouldnot require capitalization.

G. Safe harbor pooling methods

The final regulations adopt, with slightmodifications, the pooling methods con-

2004-7 I.R.B. 451 February 17, 2004

tained in the proposed regulations for deminimis costs and the 12-month rule. Thepooling rules in the final regulations arevery general. However, the IRS may pub-lish guidance in the Internal Revenue Bul-letin prescribing additional rules for apply-ing the pooling methods to particular in-dustries or to specific types of transactions.

The final regulations provide that ataxpayer may utilize the pooling methodsonly if the taxpayer reasonably expectsto engage in at least 25 similar transac-tions during the taxable year. The finalregulations require a minimum numberof similar transactions to prevent inap-propriate skewing of the average cost oraverage benefit period. Although poolingreduces the burden on taxpayers of havingto separately analyze each transaction, thisburden is not as significant when thereare only a small number of transactions toconsider.

The final regulations do not require thesame pools to be used under the poolingmethod as are required for depreciationpurposes under section 167. However, tax-payers should draw no inferences that apool permitted under the regulations con-stitutes an acceptable pool for depreciationpurposes under section 167.

A commentator suggested that the fi-nal regulations permit taxpayers to esti-mate the costs (or renewal expectancy) ofitems included in a pool based on a sam-ple of items included in the pool. The fi-nal regulations do not adopt this sugges-tion. The IRS and Treasury Departmentbelieve that it is inappropriate to apply thepooling rules by looking at a sample ofitems included in the pool. In estimatingthe renewal expectancy of items in a pool,however, taxpayers are permitted to con-sider their historic experience with similaritems.

The final regulations clarify that apooling method authorized by the regula-tions constitutes a method of accounting.Accordingly, a taxpayer that adopts (orchanges to) a pooling method authorizedby the regulations must use the method forthe year of adoption (or year of change)and for all subsequent taxable years dur-ing which the taxpayer qualifies to usethe method, unless a change to anothermethod is required by the Commissioner,or unless permission to change to anothermethod is granted by the Commissioner.

The final regulations also add a rulethat is intended to prevent abuse of thede minimis rules through pooling of sim-ilar agreements. The IRS and TreasuryDepartment are concerned that one ormore large-dollar transactions may qual-ify under the de minimis rule if averagedwith numerous small-dollar transactions.To discourage this potential abuse, theregulations prohibit the inclusion of anagreement in the pool if the amount paidto obtain the agreement is reasonablyexpected to differ significantly from theaverage amount attributable to other agree-ments properly included in the pool. Thefinal regulations add an example illustrat-ing the application of this rule.

H. Computer software issues

Based on public comments, the IRS andTreasury Department decided that issuesrelating to the development and imple-mentation of computer software are moreappropriately addressed in separate guid-ance, and not in these final regulations.While these final regulations require ataxpayer to capitalize an amount paid toanother party to acquire computer softwarefrom that party in a purchase or similartransaction (see §1.263(a)–4(c)), nothingin these regulations is intended to affect thedetermination of whether computer soft-ware is acquired from another party in apurchase or similar transaction, or whethercomputer software is developed or other-wise self-created (including amounts paidto implement Enterprise Resource Plan-ning (ERP) software). While the proposedregulations identify ERP implementationcosts as an issue to be addressed in thefinal regulations, the IRS and TreasuryDepartment believe that rules regardingthe treatment of such costs are more ap-propriately addressed in separate guidancededicated exclusively to computer soft-ware issues. Until separate guidance isissued, taxpayers may continue to relyon Revenue Procedure 2000–50, 2000–2C.B. 601.

III. Explanation and Summary ofComments Concerning §1.263(a)–5

A. In general

Section 1.263(a)–5 contains rules re-quiring taxpayers to capitalize amountspaid to facilitate the acquisition of a trade

or business, a change in the capital struc-ture of a business entity, and certain othertransactions. The types of transactionscovered by §1.263(a)–5 are more clearlyidentified than in paragraph (b)(1)(iii)of the proposed regulations. Section1.263(a)–5 applies to acquisitions of anownership interest in an entity conductinga trade or business only if, immediatelyafter the acquisition, the taxpayer and theentity are related within the meaning ofsection 267(b) or 707(b). Other acquisi-tions of an ownership interest in an entityare governed by the rules contained in§1.263(a)–4, and not the rules containedin §1.263(a)–5.

Similar to the §1.263(a)–4 final regula-tions, the §1.263(a)–5 regulations clarifythat an amount facilitates a transaction ifit is paid in the process of “investigatingor otherwise pursuing the transaction” andthat an amount paid to determine the valueor price of a transaction is an amount paidin the process of investigating or otherwisepursuing that transaction. In addition, thefact that an amount would (or would not)have been paid “but for” the transaction isa relevant, but not determinative, factor inevaluating whether an amount is paid to fa-cilitate a transaction.

B. Acquisition of assets constituting atrade or business

As explained in the preamble to theproposed regulations, the proposed regu-lations (and the simplifying conventionsin the proposed regulations) apply only toamounts paid to acquire (or facilitate theacquisition of) intangibles acquired as partof a trade or business and do not applyto amounts paid to acquire (or facilitatethe acquisition of) tangible assets acquiredas part of a trade or business. The pre-amble to the proposed regulations furthernotes that the IRS and Treasury Depart-ment were considering the application ofthe rules in the proposed regulations to tan-gible assets acquired as part of a trade orbusiness in order to provide a single ad-ministrable standard in these transactions.To avoid the application of one set of rulesto intangible assets acquired in the acqui-sition of a trade or business and a differ-ent set of rules to the tangible assets ac-quired in the acquisition, the final regula-tions under §1.263(a)–5 provide a singleset of rules for amounts paid to facilitate an

February 17, 2004 452 2004-7 I.R.B.

acquisition of a trade or business, regard-less of whether the transaction is structuredas an acquisition of the entity or as an ac-quisition of assets (including tangible as-sets) constituting a trade or business.

C. Special rules for certain costs

1. Borrowing Costs

The final regulations retain the rule inthe proposed regulations that an amountpaid to facilitate a borrowing does not fa-cilitate another transaction (other than theborrowing).

2. Costs of Asset Sales

The final regulations provide that anamount paid to facilitate a sale of assetsdoes not facilitate a transaction other thanthe sale, regardless of the circumstancessurrounding the sale. This modifies therule in the proposed regulations, which re-quires capitalization of amounts paid to fa-cilitate a sale of assets where the sale is re-quired by law, regulatory mandate, or courtorder and the sale itself facilitates anothercapital transaction. Several commentatorsargued that costs to dispose of assets areproperly viewed as costs to facilitate thesale, and not costs to facilitate a subsequenttransaction. The IRS and Treasury Depart-ment have adopted this suggestion and re-vised the rule in the final regulations.

3. Mandatory Stock Distributions

The final regulations modify the rulesin the proposed regulations relating to gov-ernment mandated divestitures of stock.The proposed regulations provide that cap-italization is not required for a distribu-tion of stock by a taxpayer to its share-holders if the divestiture is required by law,regulatory mandate, or court order, exceptin cases where the divestiture itself facil-itates another capital transaction. The fi-nal regulations eliminate the exception. Inaddition, the final regulations clarify thatcosts to organize an entity to receive the di-vested properties or to facilitate the trans-fer of certain divested properties to a dis-tributed entity also are not required to becapitalized under section 263(a). See sec-tions 248 and 709. An example has beenadded to the final regulations illustratingthis rule.

4. Bankruptcy Reorganization Costs

Commentators suggested that the finalregulations clarify that not all costs in-curred in the process of pursuing a bank-ruptcy reorganization under Chapter 11 ofthe Bankruptcy Code must be capitalized.The final regulations contain a special ruledefining the scope of bankruptcy costs re-quired to be capitalized. Under the rule,costs of the debtor to institute or admin-ister a Chapter 11 proceeding generallyare required to be capitalized. However,costs to operate the debtor’s business dur-ing a Chapter 11 proceeding (including thetypes of costs described in Revenue Rul-ing 77–204, 1977–1 C.B. 40) do not fa-cilitate the bankruptcy and are treated inthe same manner as such costs would havebeen treated had the bankruptcy proceed-ing not been instituted. In addition, thefinal regulations provide that capitaliza-tion is not required for amounts paid by ataxpayer to defend against the commence-ment of an involuntary bankruptcy pro-ceeding against the taxpayer.

Commentators specifically requestedthat the final regulations address the treat-ment of costs incurred in a Chapter 11bankruptcy proceeding that is instituted inorder to manage and resolve tort claimsand distinguish these proceedings fromother bankruptcy cases. The final reg-ulations do not distinguish between abankruptcy proceeding that is instituted toresolve tort claims and other bankruptcyproceedings. However, the final regula-tions clarify that a specific amount paidto formulate, analyze, contest or obtainapproval of the portion of a plan of reor-ganization under Chapter 11 that resolvesthe taxpayer’s tort liability is not requiredto be capitalized if the amount would havebeen treated as an ordinary and necessarybusiness expense under section 162 hadthe bankruptcy proceeding not been insti-tuted.

5. Stock Issuance Costs of Open-EndRegulated Investment Companies

The final regulations retain the rule thatamounts paid by an open-end regulated in-vestment company to facilitate an issuanceof its stock are treated as amounts thatdo not facilitate a capital transaction un-less the amounts are paid during the initialstock offering period.

6. Integration Costs

The final regulations retain the rule inthe proposed regulations that an amountpaid to integrate the business operationsof the taxpayer with the business opera-tions of another entity does not facilitatea transaction described in §1.263(a)–5, re-gardless of when the integration activitiesoccur.

7. Costs Associated with TerminatedTransactions

The final regulations clarify when costsof terminating a transaction described in§1.263(a)–5 (including break-up fees) aretreated as facilitating another transactiondescribed in §1.263(a)–5. Under the pro-posed regulations, termination costs facil-itate a subsequent transaction if the sub-sequent transaction is “expressly condi-tioned” on the termination. The final reg-ulations do not contain an “expressly con-ditioned” rule. Instead, an amount paid toterminate (or facilitate the termination of)an agreement to enter into a transaction de-scribed in the regulations is treated as facil-itating another transaction described in theregulations only if the transactions are mu-tually exclusive and the agreement is ter-minated to enable the taxpayer to engagein the second transaction. In addition, anamount paid to facilitate a transaction de-scribed in the regulations is treated as fa-cilitating a second transaction described inthe regulations only if the transactions aremutually exclusive and the first transac-tion is abandoned to enable the taxpayer toengage in the second transaction. The fi-nal regulations contain several examples todemonstrate the application of these rules.

D. Simplifying conventions

In general, the simplifying conventionsapplicable to transactions described in§1.263(a)–5 are similar to the simplify-ing conventions applicable to acquisitionsor creations of intangibles governed by§1.263(a)–4. See Part II.E.2 of this Pre-amble titled “Simplifying Conventions”for an explanation of the simplifying con-ventions applicable to the acquisition orcreation of an intangible governed by§1.263(a)–4.

The simplifying convention for em-ployee compensation treats amounts paidto persons who are not employees as

2004-7 I.R.B. 453 February 17, 2004

employee compensation if the amountsare paid for secretarial, clerical, or sim-ilar administrative support services. Inthe context of transactions described in§1.263(a)–5, this rule does not apply toservices involving the preparation and dis-tribution of proxy solicitations and otherdocuments seeking shareholder approvalof a transaction described in §1.263(a)–5.The IRS and Treasury Department believethat these inherently facilitative services,which are commonly performed by in-dependent contractors, are appropriatelycapitalized.

In addition, the final regulations pro-vide that the term “de minimis costs” doesnot include commissions paid to facilitatea transaction described in §1.263(a)–5.This rule maintains consistency with therule in §1.263(a)–4(e)(4)(iii)(B), whichprovides that the de minimis rule does notapply to commissions paid to facilitate theacquisition or creation of certain financialinterests.

E. Special rules for certain acquisitivetransactions

The final regulations contain a “brightline date” rule and an “inherently facilita-tive” rule intended to aid the determinationof amounts paid to facilitate certain acquis-itive transactions. The final regulationsmodify the bright line date rule provided inthe proposed regulations. Under the finalregulations, an amount (that is not an in-herently facilitative amount) facilitates thetransaction only if the amount relates toactivities performed on or after the earlierof (i) the date on which a letter of intent,exclusivity agreement, or similar writtencommunication is executed by representa-tives of the acquirer and the target or (ii)the date on which the material terms of thetransaction are authorized or approved bythe taxpayer’s board of directors (or otherappropriate governing officials). Whereboard approval is not required for a par-ticular transaction, the bright line date forthe second prong of the test is the dateon which the acquirer and the target exe-cute a binding written contract reflectingthe terms of the transaction.

Many comments were received con-cerning the bright line dates. Some com-mentators noted that any bright line dateis inappropriate and that the determinationshould be based on all of the facts and

circumstances surrounding the transac-tion. As discussed in the preamble to theproposed regulations, the IRS and Trea-sury Department continue to believe thata bright line rule is necessary to eliminatethe subjectivity and controversy inherentin this area. Further, the IRS and TreasuryDepartment believe that the bright linerule is within the scope of the authorityof the IRS and Treasury Department toprescribe rules necessary to enforce therequirements of section 263(a), and thatthe bright line rule, as modified in thesefinal regulations, serves as an appropriateand objective standard for determiningthe point in time at which amounts paidin certain acquisitive transactions must becapitalized.

Some commentators who agreed withthe use of a bright line date rule to im-prove administrability of section 263(a)suggested that the bright line date shouldbe the date the taxpayer’s board of direc-tors approves a transaction. The date ofthe board of directors approval may, insome cases, be the date determined underthe rule contained in the final regulations.However, the IRS and Treasury Depart-ment believe that an earlier date is moreappropriate where the parties have mutu-ally agreed to pursue a transaction, not-withstanding the fact that the parties arenot bound to complete the transaction. Ac-cordingly, the rule requires capitalization ifthe parties execute a letter of intent, exclu-sivity agreement, or similar written com-munication. The term similar written com-munication in the rule is not intended to in-clude a confidentiality agreement.

The board of directors approval datecontemplated by the rule is not the date theboard authorizes a committee (or manage-ment) to explore the possibility of a trans-action with another party. Additionally,the board of directors approval date con-templated by the rule is not intended tobe the date the board ratifies a shareholdervote in favor of the transaction.

Some commentators suggested that thefinal regulations clarify how the bright linedate rule applies to a target that puts itselfup for auction. These commentators notedthat, under the proposed regulations, sub-mission of a bid by a bidder could triggerthe bright line date for the target, even ifthe target has not made any decision re-garding the bid. Under the final regula-tions, submission of a bid by a bidder does

not trigger the bright line date for the tar-get because the first part of the test requiresexecution by both the acquirer and the tar-get and the second part of the test is appliedindependently by the acquirer and the tar-get. The final regulations include an exam-ple illustrating the application of the rule inthis case.

The final regulations specifically iden-tify the types of transactions to which thebright line date and inherently facilitativerules apply. Some commentators sug-gested that the final regulations extend therule to apply not only to acquisitive trans-actions, but to spin-offs, stock offerings,and acquisitions of individual assets thatdo not constitute a trade or business. TheIRS and Treasury Department believe thatthe bright line test is not suitable for thesetransactions and that amounts paid in theprocess of investigating or otherwise pur-suing these transactions are appropriatelycapitalized.

Regarding the inherently facilitativerule contained in the proposed regula-tions, several commentators suggestedthat the rule be deleted or changed to arebuttable presumption that the identifiedamounts are capital. The final regulationsdo not adopt this suggestion. The IRS andTreasury Department believe that the listof inherently facilitative amounts prop-erly identifies certain types of costs thatare capital regardless of when they areincurred. In addition, a rebuttable pre-sumption would not provide the certaintysought by the regulations. However, thefinal regulations modify the list of inher-ently facilitative amounts to more clearlyidentify the types of costs considered in-herently facilitative. For example, theproposed regulations treat “amounts paidfor activities performed in determiningthe value of the target” as inherently fa-cilitative costs. Commentators expressedconcerns that this language would requiretaxpayers to capitalize all due diligencecosts. The final regulations tighten thiscategory to include amounts paid for “se-curing an appraisal, formal written eval-uation, or fairness opinion related to thetransaction.” General due diligence costsare intended to be addressed by the brightline test, not the inherently facilitativerules.

Some commentators questionedwhether the regulations are intended toaffect the treatment of an expenditure un-

February 17, 2004 454 2004-7 I.R.B.

der section 195. As a result of section195(c)(1)(B), the regulations are relevantin determining whether an expenditureconstitutes a start-up expenditure withinthe meaning of section 195. An amountcannot constitute a start-up expenditurewithin the meaning of section 195(c)(1)(B)if the amount is a capital expenditure un-der section 263(a). Accordingly, amountsrequired to be capitalized under the finalregulations do not constitute start-up ex-penditures within the meaning of section195(c)(1). Conversely, amounts that arenot required to be capitalized under thefinal regulations may constitute start-upexpenditures within the meaning of section195(c)(1) provided the other requirementsof that section are met.

F. Hostile takeover defense costs

The IRS and Treasury Department de-cided that the rules in the proposed regula-tions for amounts paid to defend against ahostile takeover attempt are unnecessary.The hostile transaction rule in the pro-posed regulations does not permit taxpay-ers to deduct costs that otherwise wouldhave been capitalized under the regula-tions. For example, the hostile transactionrule does not apply to any inherently fa-cilitative costs or to costs that facilitate an-other capital transaction (for example, a re-capitalization or a proposed merger with awhite knight). Other amounts that a targetwould pay in defending against a hostileacquisition would not be capitalized un-der the final regulations either because thecosts would not be paid in investigating orotherwise pursuing the transaction with thehostile acquirer (for example, costs to seekan injunction against the acquisition) orwould relate to activities performed beforethe bright line dates (while the transactionis hostile, the target will not execute anyagreements with the acquirer and the tar-get’s board of directors will not authorizethe acquisition). Thus, the IRS and Trea-sury Department believe the hostile trans-action rule in the proposed regulations isunnecessary and could cause needless con-troversy over when a transaction changesfrom hostile to friendly. Accordingly, thefinal regulations do not contain any spe-cial rules related to hostile acquisition at-tempts. The final regulations contain anexample illustrating how the regulations

apply in the context of a hostile acquisitionattempt.

G. Documentation of success-based fees

Under the proposed regulations, a pay-ment that is contingent on the success-ful closing of an acquisition facilitates theacquisition except to the extent that evi-dence clearly demonstrates that some por-tion of the payment is allocable to ac-tivities that do not facilitate the acquisi-tion. The final regulations retain the suc-cess-based fee rule, but extend it to alltransactions to which §1.263(a)–5 applies,instead of just acquisitive transactions. Inaddition, the final regulations eliminate the“clearly demonstrates” standard in favorof a rule providing that success-based feesfacilitate a transaction except to the ex-tent the taxpayer maintains sufficient doc-umentation to establish that a portion ofthe fee is allocable to activities that do notfacilitate the transaction. The regulationsrequire that this documentation consist ofmore than a mere allocation between activ-ities that facilitate the transaction and ac-tivities that do not facilitate the transaction.

H. Treatment of capitalized costs

The final regulations provide thatamounts required to be capitalized by anacquirer in a taxable acquisitive transac-tion are added to the basis of the acquiredassets in an asset transaction or to the basisof the acquired stock in a stock transac-tion. Amounts required to be capitalizedby the target in an acquisition of its assetsin a taxable transaction are treated as areduction of the target’s amount realizedon the disposition of its assets.

The final regulations do not addressthe treatment of amounts required to becapitalized in certain other transactionsto which §1.263(a)–5 applies (for exam-ple, amounts required to be capitalizedin tax-free transactions, costs of a targetin a taxable stock acquisition and stockissuance costs). The IRS and Treasury De-partment intend to issue separate guidanceto address the treatment of these amountsand will consider at that time whether suchamounts should be eligible for the 15-yearsafe harbor amortization period describedin §1.167(a)–3.

IV. Effective Dates and Changes inMethods of Accounting

The final regulations under§§1.263(a)–4 and 1.263(a)–5 applyto amounts paid or incurred on or afterDecember 31, 2003. Except as providedbelow regarding changes to a poolingmethod authorized by these regulations,a taxpayer seeking to change a methodof accounting to comply with the finalregulations must make the change on amodified cut-off basis, taking into accountfor purposes of section 481(a) onlyamounts paid or incurred in taxable yearsending on or after January 24, 2002 (thedate of publication of the advance noticeof proposed rulemaking in the FederalRegister).

As explained in the preamble to theproposed regulations, the IRS and Trea-sury Department are concerned that anunrestricted section 481(a) adjustment forchanges in methods of accounting madeto comply with these regulations wouldcreate administrative burdens on taxpay-ers and the IRS. In addition, many of thesimplification conventions in the finalregulations (including the 12-month ruleand the rules for employee compensation,overhead and de minimis costs) representa change in the position traditionally takenby the IRS and the Treasury Department ininterpreting section 263(a). However, theIRS and Treasury Department also wantto reduce the potential for inconsistenttreatment of conservative and aggressivetaxpayers. Allowing a section 481(a) ad-justment for amounts paid or incurred intaxable years ending on or after the dateof the advance notice of proposed rule-making achieves the best balance of theseconcerns.

For changes relating to the use of apooling method under §1.263(a)–4, tax-payers must apply a cut-off method. Ap-plying a cut-off method reduces the burdenon taxpayers of having to determine whichassets fit into a pool on a retroactive basis.

The preamble to the proposed regu-lations provides that taxpayers may notchange a method of accounting in relianceupon the rules contained in the proposedregulations until the rules are published asfinal regulations. Nonetheless, the IRS hasreceived numerous Forms 3115 from tax-payers seeking the Commissioner’s con-sent to change their method of accounting

2004-7 I.R.B. 455 February 17, 2004

for items addressed in the advance noticeof proposed rulemaking or in the pro-posed regulations. The IRS suspendedprocessing of these requests pending pub-lication of these final regulations. Uponpublication of the final regulations, theIRS intends to process these requests ina manner consistent with the rules con-tained in the final regulations, includingthe effective date rules and rules relatingto the computation of the section 481(a)adjustment. For example, if the change isrequested for a taxable year ending priorto the effective date of the final regulationsand concerns a method of accounting thatthe Commissioner does not recognize aspermissible prior to the effective date ofthe final regulations, the IRS intends toreject the request. Similarly, if the changeis requested for a taxable year ending on orafter the effective date of the final regula-tions and concerns a method of accountingthat is permissible under the final regula-tions, the IRS intends to return the requestto the taxpayer (and refund the user fee)and advise the taxpayer to utilize the au-tomatic consent procedures as authorizedby the final regulations. Subsequent tothe publication of these final regulations,the IRS may issue additional guidance forutilizing the automatic consent proceduresas authorized by these regulations. Un-less these regulations specifically identifya treatment of amounts as a method ofaccounting (for example, the safe harborpooling methods), nothing in these reg-ulations is intended to address whetherthe treatment of amounts to which theseregulations apply constitutes a method ofaccounting.

V. Explanation of Amendments to§1.167(a)–3

The final regulations essentially retainthe amendments to §1.167(a)–3 as con-tained in the proposed regulations. The fi-nal regulations provide that those amend-ments are effective for intangible assetscreated on or after the date the final reg-ulations are published in the Federal Reg-ister.

Special Analyses

It has been determined that this Trea-sury decision is not a significant regula-tory action as defined in Executive Order12866. Therefore, a regulatory assessment

is not required. It also has been determinedthat section 553(b) of the AdministrativeProcedure Act (5 U.S.C. chapter 5) doesnot apply to these regulations. It is herebycertified that the collection of informationrequirement in these regulations will nothave a significant economic impact on asubstantial number of small entities. Thiscertification is based on the fact that theregulations merely require a taxpayer to re-tain records substantiating amounts paid inthe process of investigating or otherwisepursuing certain transactions involving theacquisition of a trade or business. There-fore, a Regulatory Flexibility Analysis isnot required. Pursuant to section 7805(f)of the Code, the notice of proposed rule-making preceding this regulation was sub-mitted to the Chief Counsel for Advocacyof the Small Business Administration forcomment on its impact on small business.The Chief Counsel for Advocacy did notsubmit any comments on the regulations.

Drafting Information

The principal author of these final reg-ulations is Andrew J. Keyso of the Officeof Associate Chief Counsel (Income Taxand Accounting). However, other person-nel from the IRS and Treasury Departmentparticipated in their development.

* * * * *

Adoption of Amendments to theRegulations

Accordingly, 26 CFR part 1 is amendedas follows:

PART I — INCOME TAXES

Paragraph 1. The authority citation forpart 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *Par. 2. Section 1.167(a)–3 is amended

by:1. Designating the text of the section

as paragraph (a) and adding a heading tonewly designated paragraph (a).

2. Adding paragraph (b).The additions read as follows:

§1.167(a)–3 Intangibles.

(a) In general. * * *(b) Safe harbor amortization for certain

intangible assets — (1) Useful life. Solely

for purposes of determining the deprecia-tion allowance referred to in paragraph (a)of this section, a taxpayer may treat an in-tangible asset as having a useful life equalto 15 years unless —

(i) An amortization period or usefullife for the intangible asset is specificallyprescribed or prohibited by the InternalRevenue Code, the regulations thereunder(other than by this paragraph (b)), or otherpublished guidance in the Internal Rev-enue Bulletin (see §601.601(d)(2) of thischapter);

(ii) The intangible asset is describedin §1.263(a)–4(c) (relating to intangi-bles acquired from another person) or§1.263(a)–4(d)(2) (relating to created fi-nancial interests);

(iii) The intangible asset has a usefullife the length of which can be estimatedwith reasonable accuracy; or

(iv) The intangible asset is describedin §1.263(a)–4(d)(8) (relating to certainbenefits arising from the provision, pro-duction, or improvement of real property),in which case the taxpayer may treat theintangible asset as having a useful lifeequal to 25 years solely for purposes ofdetermining the depreciation allowancereferred to in paragraph (a) of this section.

(2) Applicability to acquisitions of atrade or business, changes in the capitalstructure of a business entity, and certainother transactions. The safe harbor use-ful life provided by paragraph (b)(1) ofthis section does not apply to an amountrequired to be capitalized by §1.263(a)–5(relating to amounts paid to facilitate anacquisition of a trade or business, a changein the capital structure of a business entity,and certain other transactions).

(3) Depreciation method. A taxpayerthat determines its depreciation allowancefor an intangible asset using the 15-yearuseful life prescribed by paragraph (b)(1)of this section (or the 25-year useful lifein the case of an intangible asset describedin §1.263(a)–4(d)(8)) must determine theallowance by amortizing the basis of theintangible asset (as determined under sec-tion 167(c) and without regard to salvagevalue) ratably over the useful life begin-ning on the first day of the month in whichthe intangible asset is placed in service bythe taxpayer. The intangible asset is not el-igible for amortization in the month of dis-position.

February 17, 2004 456 2004-7 I.R.B.

(4) Effective date. This paragraph (b)applies to intangible assets created on orafter December 31, 2003.

Par. 3. Section 1.263(a)–0 is added toread as follows:

§1.263(a)–0 Table of contents.

This section lists captioned para-graphs contained in §§1.263(a)–1 through1.263(a)–5.

§1.263(a)–1 Capital expenditures; ingeneral.

§1.263(a)–2 Examples of capitalexpenditures.

§1.263(a)–3 Election to deduct orcapitalize certain expenditures.

§1.263(a)–4 Amounts paid to acquire orcreate intangibles.

(a) Overview.(b) Capitalization with respect to intangi-bles.(1) In general.(2) Published guidance.(3) Separate and distinct intangible asset.(i) Definition.(ii) Creation or termination of contractrights.(iii) Amounts paid in performing services.(iv) Creation of computer software.(v) Creation of package design.(4) Coordination with other provisions ofthe Internal Revenue Code.(i) In general.(ii) Example.(c) Acquired intangibles.(1) In general.(2) Readily available software.(3) Intangibles acquired from an em-ployee.(4) Examples.(d) Created intangibles.(1) In general.(2) Financial interests.(i) In general.(ii) Amounts paid to create, originate, enterinto, renew or renegotiate.(iii) Renegotiate.(iv) Coordination with other provisions ofthis paragraph (d).(v) Coordination with §1.263(a)–5.(vi) Examples.(3) Prepaid expenses.(i) In general.

(ii) Examples.(4) Certain memberships and privileges.(i) In general.(ii) Examples.(5) Certain rights obtained from a govern-ment agency.(i) In general.(ii) Examples.(6) Certain contract rights.(i) In general.(ii) Amounts paid to create, originate, enterinto, renew or renegotiate.(iii) Renegotiate.(iv) Right.(v) De minimis amounts.(vi) Exception for lessee construction al-lowances.(vii) Examples.(7) Certain contract terminations.(i) In general.(ii) Certain break-up fees.(iii) Examples.(8) Certain benefits arising from the pro-vision, production, or improvement of realproperty.(i) In general.(ii) Exclusions.(iii) Real property.(iv) Impact fees and dedicated improve-ments.(v) Examples.(9) Defense or perfection of title to intan-gible property.(i) In general.(ii) Certain break-up fees.(iii) Example.(e) Transaction costs.(1) Scope of facilitate.(i) In general.(ii) Treatment of termination payments.(iii) Special rule for contracts.(iv) Borrowing costs.(v) Special rule for stock redemption costsof open-end regulated investment compa-nies.(2) Coordination with paragraph (d) of thissection.(3) Transaction.(4) Simplifying conventions.(i) In general.(ii) Employee compensation.(iii) De minimis costs.(iv) Election to capitalize.(5) Examples.(f) 12-month rule.(1) In general.(2) Duration of benefit for contract termi-nations.

(3) Inapplicability to created financial in-terests and self-created amortizable sec-tion 197 intangibles.(4) Inapplicability to rights of indefiniteduration.(5) Rights subject to renewal.(i) In general.(ii) Reasonable expectancy of renewal.(iii) Safe harbor pooling method.(6) Coordination with section 461.(7) Election to capitalize.(8) Examples.(g) Treatment of capitalized costs.(1) In general.(2) Financial instruments.(h) Special rules applicable to pooling.(1) In general.(2) Method of accounting.(3) Adopting or changing to a poolingmethod.(4) Definition of pool.(5) Consistency requirement.(6) Additional guidance pertaining to pool-ing.(7) Example.(i) [Reserved].(j) Application to accrual method taxpay-ers.(k) Treatment of related parties and indi-rect payments.(l) Examples.(m) Amortization.(n) Intangible interests in land [Reserved].(o) Effective date.(p) Accounting method changes.(1) In general.(2) Scope limitations.(3) Section 481(a) adjustment.

§1.263(a)–5 Amounts paid or incurredto facilitate an acquisition of a trade orbusiness, a change in the capital structureof a business entity, and certain othertransactions.

(a) General rule.(b) Scope of facilitate.(1) In general.(2) Ordering rules.(c) Special rules for certain costs.(1) Borrowing costs.(2) Costs of asset sales.(3) Mandatory stock distributions.(4) Bankruptcy reorganization costs.(5) Stock issuance costs of open-end regu-lated investment companies.(6) Integration costs.

2004-7 I.R.B. 457 February 17, 2004

(7) Registrar and transfer agent fees for themaintenance of capital stock records.(8) Termination payments and amountspaid to facilitate mutually exclusive trans-actions.(d) Simplifying conventions.(1) In general.(2) Employee compensation.(i) In general.(ii) Certain amounts treated as employeecompensation.(3) De minimis costs.(i) In general.(ii) Treatment of commissions.(4) Election to capitalize.(e) Certain acquisitive transactions.(1) In general.(2) Exception for inherently facilitativeamounts.(3) Covered transactions.(f) Documentation of success-based fees.(g) Treatment of capitalized costs.(1) Tax-free acquisitive transactions [Re-served].(2) Taxable acquisitive transactions.(i) Acquirer.(ii) Target.(3) Stock issuance transactions [Re-served].(4) Borrowings.(5) Treatment of capitalized amounts byoption writer.(h) Application to accrual method taxpay-ers.(i) [Reserved].(j) Coordination with other provisions ofthe Internal Revenue Code.(k) Treatment of indirect payments.(l) Examples.(m) Effective date.(n) Accounting method changes.(1) In general.(2) Scope limitations.(3) Section 481(a) adjustment.

Par. 4. Sections 1.263(a)–4 and1.263(a)–5 are added to read as follows:

§1.263(a)–4 Amounts paid to acquire orcreate intangibles.

(a) Overview. This section providesrules for applying section 263(a) toamounts paid to acquire or create in-tangibles. Except to the extent provided inparagraph (d)(8) of this section, the rulesprovided by this section do not apply toamounts paid to acquire or create tangibleassets. Paragraph (b) of this section pro-

vides a general principle of capitalization.Paragraphs (c) and (d) of this section iden-tify intangibles for which capitalizationis specifically required under the generalprinciple. Paragraph (e) of this sectionprovides rules for determining the extentto which taxpayers must capitalize trans-action costs. Paragraph (f) of this sectionprovides a 12-month rule intended to sim-plify the application of the general princi-ple to certain payments that create benefitsof a brief duration. Additional rules andexamples relating to these provisions areprovided in paragraphs (g) through (n) ofthis section. The applicability date of therules in this section is provided in para-graph (o) of this section. Paragraph (p) ofthis section provides rules applicable tochanges in methods of accounting made tocomply with this section.

(b) Capitalization with respect to intan-gibles — (1) In general. Except as other-wise provided in this section, a taxpayermust capitalize —

(i) An amount paid to acquire an intan-gible (see paragraph (c) of this section);

(ii) An amount paid to create an intangi-ble described in paragraph (d) of this sec-tion;

(iii) An amount paid to create or en-hance a separate and distinct intangible as-set within the meaning of paragraph (b)(3)of this section;

(iv) An amount paid to create or en-hance a future benefit identified in pub-lished guidance in the Federal Registeror in the Internal Revenue Bulletin (see§601.601(d)(2)(ii) of this chapter) as anintangible for which capitalization is re-quired under this section; and

(v) An amount paid to facilitate (withinthe meaning of paragraph (e)(1) of this sec-tion) an acquisition or creation of an intan-gible described in paragraph (b)(1)(i), (ii),(iii) or (iv) of this section.

(2) Published guidance. Any publishedguidance identifying a future benefit as anintangible for which capitalization is re-quired under paragraph (b)(1)(iv) of thissection applies only to amounts paid on orafter the date of publication of the guid-ance.

(3) Separate and distinct intangible as-set — (i) Definition. The term separateand distinct intangible asset means a prop-erty interest of ascertainable and measur-able value in money’s worth that is subjectto protection under applicable state, fed-

eral or foreign law and the possession andcontrol of which is intrinsically capable ofbeing sold, transferred or pledged (ignor-ing any restrictions imposed on assignabil-ity) separate and apart from a trade or busi-ness. In addition, for purposes of this sec-tion, a fund (or similar account) is treatedas a separate and distinct intangible assetof the taxpayer if amounts in the fund (oraccount) may revert to the taxpayer. Thedetermination of whether a payment cre-ates a separate and distinct intangible as-set is made based on all of the facts andcircumstances existing during the taxableyear in which the payment is made.

(ii) Creation or termination of contractrights. Amounts paid to another party tocreate, originate, enter into, renew or rene-gotiate an agreement with that party thatproduces rights or benefits for the taxpayer(and amounts paid to facilitate the cre-ation, origination, enhancement, renewalor renegotiation of such an agreement) aretreated as amounts that do not create (or fa-cilitate the creation of) a separate and dis-tinct intangible asset within the meaningof this paragraph (b)(3). Further, amountspaid to another party to terminate (or fa-cilitate the termination of) an agreementwith that party are treated as amounts thatdo not create a separate and distinct in-tangible asset within the meaning of thisparagraph (b)(3). See paragraphs (d)(2),(d)(6), and (d)(7) of this section for rulesthat specifically require capitalization ofamounts paid to create or terminate certainagreements.

(iii) Amounts paid in performing ser-vices. Amounts paid in performing ser-vices under an agreement are treated asamounts that do not create a separate anddistinct intangible asset within the mean-ing of this paragraph (b)(3), regardless ofwhether the amounts result in the creationof an income stream under the agreement.

(iv) Creation of computer software. Ex-cept as otherwise provided in the InternalRevenue Code, the regulations thereunder,or other published guidance in the FederalRegister or in the Internal Revenue Bul-letin (see §601.601(d)(2)(ii) of this chap-ter), amounts paid to develop computersoftware are treated as amounts that do notcreate a separate and distinct intangible as-set within the meaning of this paragraph(b)(3).

(v) Creation of package design.Amounts paid to develop a package de-

February 17, 2004 458 2004-7 I.R.B.

sign are treated as amounts that do notcreate a separate and distinct intangibleasset within the meaning of this paragraph(b)(3). For purposes of this section, theterm package design means the specificgraphic arrangement or design of shapes,colors, words, pictures, lettering, and otherelements on a given product package, orthe design of a container with respect toits shape or function.

(4) Coordination with other provisionsof the Internal Revenue Code — (i) In gen-eral. Nothing in this section changes thetreatment of an amount that is specificallyprovided for under any other provision ofthe Internal Revenue Code (other than sec-tion 162(a) or 212) or the regulations there-under.

(ii) Example. The following exampleillustrates the rule of this paragraph (b)(4):

Example. On January 1, 2004, G enters into aninterest rate swap agreement with unrelated counter-party H under which, for a term of five years, Gis obligated to make annual payments at 11% andH is obligated to make annual payments at LIBORon a notional principal amount of $100 million. Atthe time G and H enter into this swap agreement,the rate for similar on-market swaps is LIBOR to10%. To compensate for this difference, on January 1,2004, H pays G a yield adjustment fee of $3,790,786.This yield adjustment fee constitutes an amount paidto create an intangible and would be capitalized un-der paragraph (d)(2) of this section. However, be-cause the yield adjustment fee is a nonperiodic pay-ment on a notional principal contract as defined in§1.446–3(c), the treatment of this fee is governed by§1.446–3 and not this section.

(c) Acquired intangibles — (1) In gen-eral. A taxpayer must capitalize amountspaid to another party to acquire any intan-gible from that party in a purchase or sim-ilar transaction. Examples of intangibleswithin the scope of this paragraph (c) in-clude, but are not limited to, the following(if acquired from another party in a pur-chase or similar transaction):

(i) An ownership interest in a corpora-tion, partnership, trust, estate, limited lia-bility company, or other entity.

(ii) A debt instrument, deposit, strippedbond, stripped coupon (including a servic-ing right treated for federal income tax pur-poses as a stripped coupon), regular inter-est in a REMIC or FASIT, or any other in-tangible treated as debt for federal incometax purposes.

(iii) A financial instrument, such as —(A) A notional principal contract;(B) A foreign currency contract;(C) A futures contract;

(D) A forward contract (including anagreement under which the taxpayer hasthe right and obligation to provide or to ac-quire property (or to be compensated forsuch property, regardless of whether thetaxpayer provides or acquires the prop-erty));

(E) An option (including an agreementunder which the taxpayer has the right toprovide or to acquire property (or to becompensated for such property, regardlessof whether the taxpayer provides or ac-quires the property)); and

(F) Any other financial derivative.(iv) An endowment contract, annuity

contract, or insurance contract.(v) Non-functional currency.(vi) A lease.(vii) A patent or copyright.(viii) A franchise, trademark or trade-

name (as defined in §1.197–2(b)(10)).(ix) An assembled workforce (as de-

fined in §1.197–2(b)(3)).(x) Goodwill (as defined in §1.197–

2(b)(1)) or going concern value (as definedin §1.197–2(b)(2)).

(xi) A customer list.(xii) A servicing right (for example,

a mortgage servicing right that is nottreated for federal income tax purposes asa stripped coupon).

(xiii) A customer-based intangible(as defined in §1.197–2(b)(6)) or sup-plier-based intangible (as defined in§1.197–2(b)(7)).

(xiv) Computer software.(xv) An agreement providing either

party the right to use, possess or sell an in-tangible described in paragraphs (c)(1)(i)through (v) of this section.

(2) Readily available software. Anamount paid to obtain a nonexclusive li-cense for software that is (or has been)readily available to the general public onsimilar terms and has not been substan-tially modified (within the meaning of§1.197–2(c)(4)) is treated for purposesof this paragraph (c) as an amount paidto another party to acquire an intangiblefrom that party in a purchase or similartransaction.

(3) Intangibles acquired from an em-ployee. Amounts paid to an employee toacquire an intangible from that employeeare not required to be capitalized underthis section if the amounts are includible inthe employee’s income in connection withthe performance of services under section

61 or 83. For purposes of this section,whether an individual is an employee is de-termined in accordance with the rules con-tained in section 3401(c) and the regula-tions thereunder.

(4) Examples. The following examplesillustrate the rules of this paragraph (c):

Example 1. Debt instrument. X corporation, acommercial bank, purchases a portfolio of existingloans from Y corporation, another financial institu-tion. X pays Y $2,000,000 in exchange for the portfo-lio. The $2,000,000 paid to Y constitutes an amountpaid to acquire an intangible from Y and must be cap-italized.

Example 2. Option. W corporation owns all ofthe outstanding stock of X corporation. Y corporationholds a call option entitling it to purchase from W allof the outstanding stock of X at a certain price pershare. Z corporation acquires the call option from Yin exchange for $5,000,000. The $5,000,000 paid toY constitutes an amount paid to acquire an intangiblefrom Y and must be capitalized.

Example 3. Ownership interest in a corporation.Same as Example 2, but assume Z exercises its optionand purchases from W all of the outstanding stock ofX in exchange for $100,000,000. The $100,000,000paid to W constitutes an amount paid to acquire anintangible from W and must be capitalized.

Example 4. Customer list. N corporation, a re-tailer, sells its products through its catalog and mailorder system. N purchases a customer list from Rcorporation. N pays R $100,000 in exchange for thecustomer list. The $100,000 paid to R constitutes anamount paid to acquire an intangible from R and mustbe capitalized.

Example 5. Goodwill. Z corporation pays Wcorporation $10,000,000 to purchase all of the as-sets of W in a transaction that constitutes an appli-cable asset acquisition under section 1060(c). Ofthe $10,000,000 consideration paid in the transac-tion, $9,000,000 is allocable to tangible assets pur-chased from W and $1,000,000 is allocable to good-will. The $1,000,000 allocable to goodwill consti-tutes an amount paid to W to acquire an intangiblefrom W and must be capitalized.

(d) Created intangibles — (1) In gen-eral. Except as provided in paragraph (f)of this section (relating to the 12-monthrule), a taxpayer must capitalize amountspaid to create an intangible described inthis paragraph (d). The determination ofwhether an amount is paid to create an in-tangible described in this paragraph (d) isto be made based on all of the facts and cir-cumstances, disregarding distinctions be-tween the labels used in this paragraph (d)to describe the intangible and the labelsused by the taxpayer and other parties tothe transaction.

(2) Financial interests — (i) In gen-eral. A taxpayer must capitalize amountspaid to another party to create, originate,enter into, renew or renegotiate with thatparty any of the following financial inter-

2004-7 I.R.B. 459 February 17, 2004

ests, whether or not the interest is regularlytraded on an established market:

(A) An ownership interest in a corpora-tion, partnership, trust, estate, limited lia-bility company, or other entity.

(B) A debt instrument, deposit, strippedbond, stripped coupon (including a servic-ing right treated for federal income tax pur-poses as a stripped coupon), regular inter-est in a REMIC or FASIT, or any other in-tangible treated as debt for federal incometax purposes.

(C) A financial instrument, such as —(1) A letter of credit;(2) A credit card agreement;(3) A notional principal contract;(4) A foreign currency contract;(5) A futures contract;(6) A forward contract (including an

agreement under which the taxpayer hasthe right and obligation to provide or to ac-quire property (or to be compensated forsuch property, regardless of whether thetaxpayer provides or acquires the prop-erty));

(7) An option (including an agreementunder which the taxpayer has the right toprovide or to acquire property (or to becompensated for such property, regardlessof whether the taxpayer provides or ac-quires the property)); and

(8) Any other financial derivative.(D) An endowment contract, annuity

contract, or insurance contract that has ormay have cash value.

(E) Non-functional currency.(F) An agreement providing either party

the right to use, possess or sell a financialinterest described in this paragraph (d)(2).

(ii) Amounts paid to create, originate,enter into, renew or renegotiate. Anamount paid to another party is not paidto create, originate, enter into, renew orrenegotiate a financial interest with thatparty if the payment is made with themere hope or expectation of developing ormaintaining a business relationship withthat party and is not contingent on theorigination, renewal or renegotiation of afinancial interest with that party.

(iii) Renegotiate. A taxpayer is treatedas renegotiating a financial interest if theterms of the financial interest are modi-fied. A taxpayer also is treated as renego-tiating a financial interest if the taxpayerenters into a new financial interest with thesame party (or substantially the same par-ties) to a terminated financial interest, the

taxpayer could not cancel the terminatedfinancial interest without the consent of theother party (or parties), and the other party(or parties) would not have consented tothe cancellation unless the taxpayer en-tered into the new financial interest. Ataxpayer is treated as unable to cancel afinancial interest without the consent ofthe other party (or parties) if, under theterms of the financial interest, the taxpayeris subject to a termination penalty and theother party (or parties) to the financial in-terest modifies the terms of the penalty.

(iv) Coordination with other provisionsof this paragraph (d). An amount de-scribed in this paragraph (d)(2) that is alsodescribed elsewhere in paragraph (d) ofthis section is treated as described only inthis paragraph (d)(2).

(v) Coordination with §1.263(a)–5. See§1.263(a)–5 for the treatment of borrowingcosts and the treatment of amounts paid byan option writer.

(vi) Examples. The following examplesillustrate the rules of this paragraph (d)(2):

Example 1. Loan. X corporation, a commercialbank, makes a loan to A in the principal amount of$250,000. The $250,000 principal amount of the loanpaid to A constitutes an amount paid to another partyto create a debt instrument with that party under para-graph (d)(2)(i)(B) of this section and must be capital-ized.

Example 2. Option. W corporation owns all ofthe outstanding stock of X corporation. Y corporationpays W $1,000,000 in exchange for W’s grant of a3-year call option to Y permitting Y to purchase allof the outstanding stock of X at a certain price pershare. Y’s payment of $1,000,000 to W constitutesan amount paid to another party to create an optionwith that party under paragraph (d)(2)(i)(C)(7) of thissection and must be capitalized.

Example 3. Partnership interest. Z corporationpays $10,000 to P, a partnership, in exchange for anownership interest in P. Z’s payment of $10,000 to Pconstitutes an amount paid to another party to createan ownership interest in a partnership with that partyunder paragraph (d)(2)(i)(A) of this section and mustbe capitalized.

Example 4. Take or pay contract. Q corpora-tion, a producer of natural gas, pays $1,000,000 toR during 2005 to induce R corporation to enter into a5-year “take or pay” gas purchase contract. Under thecontract, R is liable to pay for a specified minimumamount of gas, whether or not R takes such gas. Q’spayment of $1,000,000 is an amount paid to anotherparty to induce that party to enter into an agreementproviding Q the right and obligation to provide prop-erty or be compensated for such property (regardlessof whether the property is provided) under paragraph(d)(2)(i)(C)(6) of this section and must be capitalized.

Example 5. Agreement to provide property. P cor-poration pays R corporation $1,000,000 in exchangefor R’s agreement to purchase 1,000 units of P’s prod-uct at any time within the three succeeding calendar

years. The agreement describes P’s $1,000,000 as asales discount. P’s $1,000,000 payment is an amountpaid to induce R to enter into an agreement providingP the right and obligation to provide property underparagraph (d)(2)(i)(C)(6) of this section and must becapitalized.

Example 6. Customer incentive payment. S cor-poration, a computer manufacturer, seeks to developa business relationship with V corporation, a com-puter retailer. As an incentive to encourage V to pur-chase computers from S, S enters into an agreementwith V under which S agrees that, if V purchases$20,000,000 of computers from S within 3 years fromthe date of the agreement, S will pay V $2,000,000on the date that V reaches the $20,000,000 threshold.V reaches the $20,000,000 threshold during the thirdyear of the agreement, and S pays V $2,000,000. S isnot required to capitalize its payment to V under thisparagraph (d)(2) because the payment does not pro-vide S the right or obligation to provide property anddoes not create a separate and distinct intangible as-set for S within the meaning of paragraph (b)(3)(i) ofthis section.

(3) Prepaid expenses — (i) In general.A taxpayer must capitalize prepaid ex-penses.

(ii) Examples. The following examplesillustrate the rules of this paragraph (d)(3):

Example 1. Prepaid insurance. N corporation, anaccrual method taxpayer, pays $10,000 to an insurerto obtain three years of coverage under a property andcasualty insurance policy. The $10,000 is a prepaidexpense and must be capitalized under this paragraph(d)(3). Paragraph (d)(2) of this section does not applyto the payment because the policy has no cash value.

Example 2. Prepaid rent. X corporation, a cashmethod taxpayer, enters into a 24-month lease of of-fice space. At the time of the lease signing, X prepays$240,000. No other amounts are due under the lease.The $240,000 is a prepaid expense and must be capi-talized under this paragraph (d)(3).

(4) Certain memberships and privi-leges — (i) In general. A taxpayer mustcapitalize amounts paid to an organizationto obtain, renew, renegotiate, or upgradea membership or privilege from that or-ganization. A taxpayer is not required tocapitalize under this paragraph (d)(4) anamount paid to obtain, renew, renegotiateor upgrade certification of the taxpayer’sproducts, services, or business processes.

(ii) Examples. The following examplesillustrate the rules of this paragraph (d)(4):

Example 1. Hospital privilege. B, a physician,pays $10,000 to Y corporation to obtain lifetime staffprivileges at a hospital operated by Y. B must capital-ize the $10,000 payment under this paragraph (d)(4).

Example 2. Initiation fee. X corporation pays a$50,000 initiation fee to obtain membership in a tradeassociation. X must capitalize the $50,000 paymentunder this paragraph (d)(4).

Example 3. Product rating. V corporation, anautomobile manufacturer, pays W corporation, a na-tional quality ratings association, $100,000 to con-duct a study and provide a rating of the quality andsafety of a line of V’s automobiles. V’s payment is

February 17, 2004 460 2004-7 I.R.B.

an amount paid to obtain a certification of V’s productand is not required to be capitalized under this para-graph (d)(4).

Example 4. Business process certification. Z cor-poration, a manufacturer, seeks to obtain a certifica-tion that its quality control standards meet a series ofinternational standards known as ISO 9000. Z pays$50,000 to an independent registrar to obtain a cer-tification from the registrar that Z’s quality manage-ment system conforms to the ISO 9000 standard. Z’spayment is an amount paid to obtain a certification ofZ’s business processes and is not required to be cap-italized under this paragraph (d)(4).

(5) Certain rights obtained from a gov-ernmental agency — (i) In general. Ataxpayer must capitalize amounts paid toa governmental agency to obtain, renew,renegotiate, or upgrade its rights under atrademark, trade name, copyright, license,permit, franchise, or other similar rightgranted by that governmental agency.

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

Example 1. Business license. X corporation pays$15,000 to state Y to obtain a business license thatis valid indefinitely. Under this paragraph (d)(5), theamount paid to state Y is an amount paid to a govern-ment agency for a right granted by that agency. Ac-cordingly, X must capitalize the $15,000 payment.

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

(6) Certain contract rights — (i) In gen-eral. Except as otherwise provided in thisparagraph (d)(6), a taxpayer must capital-ize amounts paid to another party to create,originate, enter into, renew or renegotiatewith that party —

(A) An agreement providing the tax-payer the right to use tangible or intangibleproperty or the right to be compensated forthe use of tangible or intangible property;

(B) An agreement providing the tax-payer the right to provide or to receive ser-vices (or the right to be compensated forservices regardless of whether the taxpayerprovides such services);

(C) A covenant not to compete or anagreement having substantially the sameeffect as a covenant not to compete (ex-cept, in the case of an agreement thatrequires the performance of services, tothe extent that the amount represents rea-sonable compensation for services actuallyrendered);

(D) An agreement not to acquire addi-tional ownership interests in the taxpayer;or

(E) An agreement providing the tax-payer (as the covered party) with an annu-ity, an endowment, or insurance coverage.

(ii) Amounts paid to create, originate,enter into, renew or renegotiate. Anamount paid to another party is not paidto create, originate, enter into, renew orrenegotiate an agreement with that party ifthe payment is made with the mere hopeor expectation of developing or maintain-ing a business relationship with that partyand is not contingent on the origination,renewal or renegotiation of an agreementwith that party.

(iii) Renegotiate. A taxpayer is treatedas renegotiating an agreement if the termsof the agreement are modified. A tax-payer also is treated as renegotiating anagreement if the taxpayer enters into a newagreement with the same party (or sub-stantially the same parties) to a terminatedagreement, the taxpayer could not cancelthe terminated agreement without the con-sent of the other party (or parties), andthe other party (or parties) would not haveconsented to the cancellation unless thetaxpayer entered into the new agreement.A taxpayer is treated as unable to cancelan agreement without the consent of theother party (or parties) if, under the termsof the agreement, the taxpayer is subject toa termination penalty and the other party(or parties) to the agreement modifies theterms of the penalty.

(iv) Right. An agreement does not pro-vide the taxpayer a right to use property orto provide or receive services if the agree-ment may be terminated at will by the otherparty (or parties) to the agreement beforethe end of the period prescribed by para-graph (f)(1) of this section. An agreementis not terminable at will if the other party(or parties) to the agreement is economi-cally compelled not to terminate the agree-ment until the end of the period prescribedby paragraph (f)(1) of this section. All ofthe facts and circumstances will be con-sidered in determining whether the otherparty (or parties) to an agreement is eco-nomically compelled not to terminate theagreement. An agreement also does notprovide the taxpayer the right to provideservices if the agreement merely providesthat the taxpayer will stand ready to pro-vide services if requested, but places no

obligation on another person to request orpay for the taxpayer’s services.

(v) De minimis amounts. A taxpayer isnot required to capitalize amounts paid toanother party (or parties) to create, origi-nate, enter into, renew or renegotiate withthat party (or those parties) an agreementdescribed in paragraph (d)(6)(i) of this sec-tion if the aggregate of all amounts paidto that party (or those parties) with respectto the agreement does not exceed $5,000.If the aggregate of all amounts paid tothe other party (or parties) with respect tothat agreement exceeds $5,000, then allamounts must be capitalized. For purposesof this paragraph (d)(6), an amount paidin the form of property is valued at itsfair market value at the time of the pay-ment. In general, a taxpayer must deter-mine whether the rules of this paragraph(d)(6)(v) apply by accounting for the spe-cific amounts paid with respect to eachagreement. However, a taxpayer that rea-sonably expects to create, originate, enterinto, renew or renegotiate at least 25 simi-lar agreements during the taxable year mayestablish a pool of agreements for purposesof determining the amounts paid with re-spect to the agreements in the pool. Underthis pooling method, the amount paid withrespect to each agreement included in thepool is equal to the average amount paidwith respect to all agreements included inthe pool. A taxpayer computes the averageamount paid with respect to all agreementsincluded in the pool by dividing the sum ofall amounts paid with respect to all agree-ments included in the pool by the numberof agreements included in the pool. Seeparagraph (h) of this section for additionalrules relating to pooling.

(vi) Exception for lessee constructionallowances. Paragraph (d)(6)(i) of thissection does not apply to amounts paid bya lessor to a lessee as a construction al-lowance to the extent the lessee expendsthe amount for the tangible property that isowned by the lessor for federal income taxpurposes (see, for example, section 110).

(vii) Examples. The following exam-ples illustrate the rules of this paragraph(d)(6):

Example 1. New lease agreement. V seeks tolease commercial property in a prominent downtownlocation of city R. V pays Z, the owner of the com-mercial property, $50,000 in exchange for Z enteringinto a 10-year lease with V. V’s payment is an amountpaid to another party to enter into an agreement pro-viding V the right to use tangible property. Because

2004-7 I.R.B. 461 February 17, 2004

the $50,000 payment exceeds $5,000, no portion ofthe amount paid to Z is de minimis for purposes ofparagraph (d)(6)(v) of this section. Under paragraph(d)(6)(i)(A) of this section, V must capitalize the en-tire $50,000 payment.

Example 2. Modification of lease agreement.Partnership Y leases a piece of equipment for usein its business from Z corporation. When the leasehas a remaining term of 3 years, Y requests that Zmodify the existing lease by extending the remainingterm by 5 years. Y pays $50,000 to Z in exchangefor Z’s agreement to modify the existing lease. Y’spayment of $50,000 is an amount paid to anotherparty to renegotiate an agreement providing Y theright to use property. Because the $50,000 paymentexceeds $5,000, no portion of the amount paid to Z isde minimis for purposes of paragraph (d)(6)(v) of thissection. Under paragraph (d)(6)(i)(A) of this section,Y must capitalize the entire $50,000 payment.

Example 3. Modification of lease agreement. In2004, R enters into a 5-year, non-cancelable lease of amainframe computer for use in its business. R subse-quently determines that the mainframe computer thatR is leasing is no longer adequate for its needs. In2006, R and P corporation (the lessor) agree to ter-minate the 2004 lease and to enter into a new 5-yearlease for a different and more powerful mainframecomputer. R pays P a $75,000 early termination fee.P would not have agreed to terminate the 2004 leaseunless R agreed to enter into the 2006 lease. R’s pay-ment of $75,000 is an amount paid to another partyto renegotiate an agreement providing R the right touse property. Because the $75,000 payment exceeds$5,000, no portion of the amount paid to P is de min-imis for purposes of paragraph (d)(6)(v) of this sec-tion. Under paragraph (d)(6)(i)(A) of this section, Rmust capitalize the entire $75,000 payment.

Example 4. Modification of lease agreement.Same as Example 3, except the 2004 lease agreementallows R to terminate the lease at any time subject toa $75,000 early termination fee. Because R can ter-minate the lease without P’s approval, R’s paymentof $75,000 is not an amount paid to another partyto renegotiate an agreement. Accordingly, R is notrequired to capitalize the $75,000 payment under thisparagraph (d)(6).

Example 5. Modification of lease agreement.Same as Example 4, except P agreed to reduce theearly termination fee to $60,000. Because R did notpay an amount to renegotiate the early terminationfee, R’s payment of $60,000 is not an amount paidto another party to renegotiate an agreement. Ac-cordingly, R is not required to capitalize the $60,000payment under this paragraph (d)(6).

Example 6. Covenant not to compete. R corpora-tion enters into an agreement with A, an individual,that prohibits A from competing with R for a periodof three years. To encourage A to enter into the agree-ment, R agrees to pay A $100,000 upon the signingof the agreement. R’s payment is an amount paid toanother party to enter into a covenant not to compete.Because the $100,000 payment exceeds $5,000, noportion of the amount paid to A is de minimis for pur-poses of paragraph (d)(6)(v) of this section. Underparagraph (d)(6)(i)(C) of this section, R must capital-ize the entire $100,000 payment.

Example 7. Standstill agreement. During 2004through 2005, X corporation acquires a large minor-ity interest in the stock of Z corporation. To ensure

that X does not take control of Z, Z pays X $5,000,000for a standstill agreement under which X agrees not toacquire any more stock in Z for a period of 10 years.Z’s payment is an amount paid to another party to en-ter into an agreement not to acquire additional owner-ship interests in Z. Because the $5,000,000 paymentexceeds $5,000, no portion of the amount paid to X isde minimis for purposes of paragraph (d)(6)(v) of thissection. Under paragraph (d)(6)(i)(D) of this section,Z must capitalize the entire $5,000,000 payment.

Example 8. Signing bonus. Employer B pays a$25,000 signing bonus to employee C to induce C tocome to work for B. C can leave B’s employment atany time to work for a competitor of B and is not re-quired to repay the $25,000 bonus to B. Because Cis not economically compelled to continue his em-ployment with B, B’s payment does not provide Bthe right to receive services from C. Accordingly, Bis not required to capitalize the $25,000 payment.

Example 9. Renewal. In 2000, M corporation andN corporation enter into a 5-year agreement that givesM the right to manage N’s investment portfolio. In2005, N has the option of renewing the agreement foranother three years. During 2004, M pays $10,000 tosend several employees of N to an investment semi-nar. M pays the $10,000 to help develop and maintainits business relationship with N with the expectationthat N will renew its agreement with M in 2005. Be-cause M’s payment is not contingent on N agreeing torenew the agreement, M’s payment is not an amountpaid to renew an agreement under paragraph (d)(6)(ii)of this section and is not required to be capitalized.

Example 10. De minimis payments. X corpo-ration is engaged in the business of providing wire-less telecommunications services to customers. Toinduce customer B to enter into a 3-year non-can-celable telecommunications contract, X provides Bwith a free wireless telephone. The fair market valueof the wireless telephone is $300 at the time it is pro-vided to B. X’s provision of a wireless telephone toB is an amount paid to B to induce B to enter into anagreement providing X the right to provide services,as described in paragraph (d)(6)(i)(B) of this section.Because the amount of the inducement is $300, theamount of the inducement is de minimis under para-graph (d)(6)(v) of this section. Accordingly, X is notrequired to capitalize the amount of the inducementprovided to B.

(7) Certain contract terminations —(i) In general. A taxpayer must capi-talize amounts paid to another party toterminate —

(A) A lease of real or tangible personalproperty between the taxpayer (as lessor)and that party (as lessee);

(B) An agreement that grants that partythe exclusive right to acquire or use thetaxpayer’s property or services or to con-duct the taxpayer’s business (other than anintangible described in paragraph (c)(1)(i)through (iv) of this section or a financialinterest described in paragraph (d)(2) ofthis section); or

(C) An agreement that prohibits the tax-payer from competing with that party or

from acquiring property or services froma competitor of that party.

(ii) Certain break-up fees. Paragraph(d)(7)(i) of this section does not apply tothe termination of a transaction describedin §1.263(a)–5(a) (relating to an acqui-sition of a trade or business, a changein the capital structure of a business en-tity, and certain other transactions). See§1.263(a)–5(c)(8) for rules governing thetreatment of amounts paid to terminate atransaction to which that section applies.

(iii) Examples. The following examplesillustrate the rules of this paragraph (d)(7):

Example 1. Termination of exclusive licenseagreement. On July 1, 2005, N enters into a licenseagreement with R corporation under which N grantsR the exclusive right to manufacture and distributegoods using N’s design and trademarks for a periodof 10 years. On June 30, 2007, N pays R $5,000,000in exchange for R’s agreement to terminate the ex-clusive license agreement. N’s payment to terminateits license agreement with R constitutes a payment toterminate an exclusive license to use the taxpayer’sproperty, as described in paragraph (d)(7)(i)(B) ofthis section. Accordingly, N must capitalize its$5,000,000 payment to R.

Example 2. Termination of exclusive distributionagreement. On March 1, 2005, L, a manufacturer, en-ters into an agreement with M granting M the right tobe the sole distributor of L’s products in state X for10 years. On July 1, 2008, L pays M $50,000 in ex-change for M’s agreement to terminate the distribu-tion agreement. L’s payment to terminate its agree-ment with M constitutes a payment to terminate anexclusive right to acquire L’s property, as described inparagraph (d)(7)(i)(B) of this section. Accordingly, Lmust capitalize its $50,000 payment to M.

Example 3. Termination of covenant not to com-pete. On February 1, 2005, Y corporation enters intoa covenant not to compete with Z corporation thatprohibits Y from competing with Z in city V for aperiod of 5 years. On January 31, 2007, Y pays Z$1,000,000 in exchange for Z’s agreement to termi-nate the covenant not to compete. Y’s payment to ter-minate the covenant not to compete with Z constitutesa payment to terminate an agreement that prohibitsY from competing with Z, as described in paragraph(d)(7)(i)(C) of this section. Accordingly, Y must cap-italize its $1,000,000 payment to Z.

Example 4. Termination of merger agreement.N corporation and U corporation enter into anagreement under which N agrees to merge into U.Subsequently, N pays U $10,000,000 to terminatethe merger agreement. As provided in paragraph(d)(7)(ii) of this section, N’s $10,000,000 paymentto terminate the merger agreement with U is not re-quired to be capitalized under this paragraph (d)(7).In addition, N’s $10,000,000 does not create a sep-arate and distinct intangible asset for N within themeaning of paragraph (b)(3)(i) of this section. (See§1.263(a)–5 for additional rules regarding termina-tion of merger agreements).

(8) Certain benefits arising from theprovision, production, or improvement ofreal property — (i) In general. A taxpayer

February 17, 2004 462 2004-7 I.R.B.

must capitalize amounts paid for real prop-erty if the taxpayer transfers ownership ofthe real property to another person (exceptto the extent the real property is sold forfair market value) and if the real propertycan reasonably be expected to produce sig-nificant economic benefits to the taxpayerafter the transfer. A taxpayer also mustcapitalize amounts paid to produce or im-prove real property owned by another (ex-cept to the extent the taxpayer is sellingservices at fair market value to produce orimprove the real property) if the real prop-erty can reasonably be expected to producesignificant economic benefits for the tax-payer.

(ii) Exclusions. A taxpayer is not re-quired to capitalize an amount under para-graph (d)(8)(i) of this section if the tax-payer transfers real property or pays anamount to produce or improve real prop-erty owned by another in exchange for ser-vices, the purchase or use of property, orthe creation of an intangible described inparagraph (d) of this section (other than inthis paragraph (d)(8)). The preceding sen-tence does not apply to the extent the tax-payer does not receive fair market valueconsideration for the real property that isrelinquished or for the amounts that arepaid by the taxpayer to produce or improvereal property owned by another.

(iii) Real property. For purposes of thisparagraph (d)(8), real property includesproperty that is affixed to real property andthat will ordinarily remain affixed for anindefinite period of time, such as roads,bridges, tunnels, pavements, wharves anddocks, breakwaters and sea walls, eleva-tors, power generation and transmissionfacilities, and pollution control facilities.

(iv) Impact fees and dedicated improve-ments. Paragraph (d)(8)(i) of this sectiondoes not apply to amounts paid to satisfyone-time charges imposed by a state or lo-cal government against new development(or expansion of existing development) tofinance specific offsite capital improve-ments for general public use that are ne-cessitated by the new or expanded devel-opment. In addition, paragraph (d)(8)(i)of this section does not apply to amountspaid for real property or improvementsto real property constructed by the tax-payer where the real property or improve-ments benefit new development or expan-sion of existing development, are imme-

diately transferred to a state or local gov-ernment for dedication to the general pub-lic use, and are maintained by the state orlocal government. See section 263A andthe regulations thereunder for capitaliza-tion rules that apply to amounts referred toin this paragraph (d)(8)(iv).

(v) Examples. The following examplesillustrate the rules of this paragraph (d)(8):

Example 1. Amount paid to produce real propertyowned by another. W corporation operates a quarryon the east side of a river in city Z and a crusher onthe west side of the river. City Z’s existing bridgesare of insufficient capacity to be traveled by trucks intransferring stone from W’s quarry to its crusher. Asa result, the efficiency of W’s operations is greatlyreduced. W contributes $1,000,000 to City Z to de-fray in part the cost of constructing a publicly ownedbridge capable of accommodating W’s trucks. W’spayment to city Z is an amount paid to produce orimprove real property (within the meaning of para-graph (d)(8)(iii) of this section) that can reasonablybe expected to produce significant economic benefitsfor W. Under paragraph (d)(8)(i) of this section, Wmust capitalize the $1,000,000 paid to city Z.

Example 2. Transfer of real property to another.K corporation, a shipping company, uses smaller ves-sels to unload its ocean-going vessels at port X. Thereis no natural harbor at port X, and during stormyweather the transfer of freight between K’s ocean ves-sels and port X is extremely difficult and sometimesimpossible, which can be very costly to K. Conse-quently, K constructs a short breakwater at a cost of$50,000. The short breakwater, however, is inade-quate, so K persuades the port authority to build alarger breakwater that will allow K to unload its ves-sels at any time of the year and during all kinds ofweather. K contributes the short breakwater and pays$200,000 to the port authority for use in building thelarger breakwater. Because the transfer of the smallbreakwater and $200,000 is reasonably expected toproduce significant economic benefits for K, K mustcapitalize both the adjusted basis of the small break-water (determined at the time the small breakwateris contributed) and the $200,000 payment under thisparagraph (d)(8).

Example 3. Dedicated improvements. X corpo-ration is engaged in the development and sale of res-idential real estate. In connection with a residentialreal estate project under construction by X in city Z,X is required by city Z to construct ingress and egressroads to and from its project and immediately trans-fer the roads to city Z for dedication to general publicuse. The roads will be maintained by city Z. X pays itssubcontractor $100,000 to construct the ingress andegress roads. X’s payment is a dedicated improve-ment within the meaning of paragraph (d)(8)(iv) ofthis section. Accordingly, X is not required to capital-ize the $100,000 payment under this paragraph (d)(8).See section 263A and the regulations thereunder forcapitalization rules that apply to amounts referred toin paragraph (d)(8)(iv) of this section.

(9) Defense or perfection of title to in-tangible property — (i) In general. A tax-payer must capitalize amounts paid to an-other party to defend or perfect title to in-

tangible property if that other party chal-lenges the taxpayer’s title to the intangibleproperty.

(ii) Certain break-up fees. Paragraph(d)(9)(i) of this section does not apply tothe termination of a transaction describedin §1.263(a)–5(a) (relating to an acqui-sition of a trade or business, a changein the capital structure of a business en-tity, and certain other transactions). See§1.263(a)–5 for rules governing the treat-ment of amounts paid to terminate a trans-action to which that section applies. Para-graph (d)(9)(i) of this section also does notapply to an amount paid to another partyto terminate an agreement that grants thatparty the right to purchase the taxpayer’sintangible property.

(iii) Example. The following exam-ple illustrates the rules of this paragraph(d)(9):

Example. Defense of title. R corporation claimsto own an exclusive patent on a particular technol-ogy. U corporation brings a lawsuit against R, claim-ing that U is the true owner of the patent and that Rstole the technology from U. The sole issue in the suitinvolves the validity of R’s patent. R chooses to settlethe suit by paying U $100,000 in exchange for U’s re-lease of all future claim to the patent. R’s payment toU is an amount paid to defend or perfect title to intan-gible property under paragraph (d)(9) of this sectionand must be capitalized.

(e) Transaction costs — (1) Scope of fa-cilitate — (i) In general. Except as other-wise provided in this section, an amount ispaid to facilitate the acquisition or creationof an intangible (the transaction) if theamount is paid in the process of investigat-ing or otherwise pursuing the transaction.Whether an amount is paid in the processof investigating or otherwise pursuing thetransaction is determined based on all ofthe facts and circumstances. In determin-ing whether an amount is paid to facili-tate a transaction, the fact that the amountwould (or would not) have been paid butfor the transaction is relevant, but is notdeterminative. An amount paid to deter-mine the value or price of an intangible isan amount paid in the process of investi-gating or otherwise pursuing the transac-tion.

(ii) Treatment of termination payments.An amount paid to terminate (or facilitatethe termination of) an existing agreementdoes not facilitate the acquisition or cre-ation of another agreement under this sec-tion. See paragraph (d)(6)(iii) of this sec-tion for the treatment of termination fees

2004-7 I.R.B. 463 February 17, 2004

paid to the other party (or parties) of a rene-gotiated agreement.

(iii) Special rule for contracts. Anamount is treated as not paid in the processof investigating or otherwise pursuing thecreation of an agreement described inparagraph (d)(2) or (d)(6) of this section ifthe amount relates to activities performedbefore the earlier of the date the taxpayerbegins preparing its bid for the agreementor the date the taxpayer begins discussingor negotiating the agreement with anotherparty to the agreement.

(iv) Borrowing costs. An amount paidto facilitate a borrowing does not facilitatean acquisition or creation of an intangibledescribed in paragraphs (b)(1)(i) through(iv) of this section. See §§1.263(a)–5 and1.446–5 for the treatment of an amountpaid to facilitate a borrowing.

(v) Special rule for stock redemp-tion costs of open-end regulated invest-ment companies. An amount paid by anopen-end regulated investment company(within the meaning of section 851) to fa-cilitate a redemption of its stock is treatedas an amount that does not facilitate theacquisition of an intangible under this sec-tion.

(2) Coordination with paragraph (d) ofthis section. In the case of an amount paidto facilitate the creation of an intangibledescribed in paragraph (d) of this section,the provisions of this paragraph (e) applyregardless of whether a payment describedin paragraph (d) is made.

(3) Transaction. For purposes of thissection, the term transaction means all ofthe factual elements comprising an acqui-sition or creation of an intangible and in-cludes a series of steps carried out as partof a single plan. Thus, a transaction caninvolve more than one invoice and morethan one intangible. For example, a pur-chase of intangibles under one purchaseagreement constitutes a single transaction,notwithstanding the fact that the acquisi-tion involves multiple intangibles and theamounts paid to facilitate the acquisitionare capable of being allocated among thevarious intangibles acquired.

(4) Simplifying conventions — (i) Ingeneral. For purposes of this section, em-ployee compensation (within the meaningof paragraph (e)(4)(ii) of this section),overhead, and de minimis costs (withinthe meaning of paragraph (e)(4)(iii) of thissection) are treated as amounts that do not

facilitate the acquisition or creation of anintangible.

(ii) Employee compensation — (A)In general. The term employee compen-sation means compensation (includingsalary, bonuses and commissions) paid toan employee of the taxpayer. For purposesof this section, whether an individual isan employee is determined in accordancewith the rules contained in section 3401(c)and the regulations thereunder.

(B) Certain amounts treated as em-ployee compensation. For purposes ofthis section, a guaranteed payment to apartner in a partnership is treated as em-ployee compensation. For purposes ofthis section, annual compensation paid toa director of a corporation is treated asemployee compensation. For example, anamount paid to a director of a corporationfor attendance at a regular meeting of theboard of directors (or committee thereof)is treated as employee compensation forpurposes of this section. However, anamount paid to a director for attendanceat a special meeting of the board of direc-tors (or committee thereof) is not treatedas employee compensation. An amountpaid to a person that is not an employeeof the taxpayer (including the employer ofthe individual who performs the services)is treated as employee compensation forpurposes of this section only if the amountis paid for secretarial, clerical, or similaradministrative support services. In thecase of an affiliated group of corporationsfiling a consolidated federal income taxreturn, a payment by one member of thegroup to a second member of the groupfor services performed by an employee ofthe second member is treated as employeecompensation if the services provided bythe employee are provided at a time duringwhich both members are affiliated.

(iii) De minimis costs — (A) In gen-eral. Except as provided in paragraph(e)(4)(iii)(B) of this section, the term deminimis costs means amounts (other thanemployee compensation and overhead)paid in the process of investigating orotherwise pursuing a transaction if, inthe aggregate, the amounts do not exceed$5,000 (or such greater amount as maybe set forth in published guidance). If theamounts exceed $5,000 (or such greateramount as may be set forth in publishedguidance), none of the amounts are deminimis costs within the meaning of this

paragraph (e)(4)(iii)(A). For purposes ofthis paragraph (e)(4)(iii), an amount paidin the form of property is valued at its fairmarket value at the time of the payment.In determining the amount of transactioncosts paid in the process of investigat-ing or otherwise pursuing a transaction, ataxpayer generally must account for thespecific costs paid with respect to eachtransaction. However, a taxpayer thatreasonably expects to enter into at least25 similar transactions during the tax-able year may establish a pool of similartransactions for purposes of determiningthe amount of transaction costs paid inthe process of investigating or otherwisepursuing the transactions in the pool. Un-der this pooling method, the amount oftransaction costs paid in the process ofinvestigating or otherwise pursuing eachtransaction included in the pool is equalto the average transaction costs paid inthe process of investigating or otherwisepursuing all transactions included in thepool. A taxpayer computes the averagetransaction costs paid in the process ofinvestigating or otherwise pursuing alltransactions included in the pool by divid-ing the sum of all transaction costs paidin the process of investigating or other-wise pursuing all transactions includedin the pool by the number of transactionsincluded in the pool. See paragraph (h) ofthis section for additional rules relating topooling.

(B) Treatment of commissions. Theterm de minimis costs does not includecommissions paid to facilitate the acqui-sition of an intangible described in para-graphs (c)(1)(i) through (v) of this sectionor to facilitate the creation, origination, en-trance into, renewal or renegotiation of anintangible described in paragraph (d)(2)(i)of this section.

(iv) Election to capitalize. A taxpayermay elect to treat employee compensation,overhead, or de minimis costs paid in theprocess of investigating or otherwise pur-suing a transaction as amounts that facili-tate the transaction. The election is madeseparately for each transaction and appliesto employee compensation, overhead, orde minimis costs, or to any combinationthereof. For example, a taxpayer may electto treat overhead and de minimis costs, butnot employee compensation, as amountsthat facilitate the transaction. A taxpayermakes the election by treating the amounts

February 17, 2004 464 2004-7 I.R.B.

to which the election applies as amountsthat facilitate the transaction in the tax-payer’s timely filed original federal in-come tax return (including extensions) forthe taxable year during which the amountsare paid. In the case of an affiliated groupof corporations filing a consolidated re-turn, the election is made separately withrespect to each member of the group, andnot with respect to the group as a whole. Inthe case of an S corporation or partnership,the election is made by the S corporationor by the partnership, and not by the share-holders or partners. An election made un-der this paragraph (e)(4)(iv) is revocablewith respect to each taxable year for whichmade only with the consent of the Com-missioner.

(5) Examples. The following examplesillustrate the rules of this paragraph (e):

Example 1. Costs to facilitate. In December2005, R corporation, a calendar year taxpayer, entersinto negotiations with X corporation to lease com-mercial property from X for a period of 25 years. Rpays A, its outside legal counsel, $4,000 in Decem-ber 2005 for services rendered by A during Decem-ber in assisting with negotiations with X. In January2006, R and X finalize the terms of the lease and ex-ecute the lease agreement. R pays B, another of itsoutside legal counsel, $2,000 in January 2006 for ser-vices rendered by B during January in drafting thelease agreement. The agreement between R and X isan agreement providing R the right to use property,as described in paragraph (d)(6)(i)(A) of this section.R’s payments to its outside counsel are amounts paidto facilitate the creation of the agreement. As pro-vided in paragraph (e)(4)(iii)(A) of this section, Rmust aggregate its transaction costs for purposes ofdetermining whether the transaction costs are de min-imis. Because R’s aggregate transaction costs exceed$5,000, R’s transaction costs are not de minimis costswithin the meaning of paragraph (e)(4)(iii)(A) of thissection. Accordingly, R must capitalize the $4,000paid to A and the $2,000 paid to B under paragraph(b)(1)(v) of this section.

Example 2. Costs to facilitate. Partnership Xleases its manufacturing equipment from Y corpora-tion under a 10-year lease. During 2005, when thelease has a remaining term of 4 years, X enters intoa written agreement with Z corporation, a competitorof Y, under which X agrees to lease its manufactur-ing equipment from Z, subject to the condition that Xfirst successfully terminates its lease with Y. X paysY $50,000 in exchange for Y’s agreement to termi-nate the equipment lease. Under paragraph (e)(1)(ii),X’s $50,000 payment does not facilitate the creationof the new lease with Z. In addition, X’s $50,000payment does not terminate an agreement describedin paragraph (d)(7) of this section. Accordingly, Xis not required to capitalize the $50,000 terminationpayment under this section.

Example 3. Costs to facilitate. W corporation en-ters into a lease agreement with X corporation underwhich W agrees to lease property to X for a period of5 years. W pays its outside counsel $7,000 for legal

services rendered in drafting the lease agreement andnegotiating with X. The agreement between W andX is an agreement providing W the right to be com-pensated for the use of property, as described in para-graph (d)(6)(i)(A) of this section. Under paragraph(e)(1)(i) of this section, W’s payment to its outsidecounsel is an amount paid to facilitate the creation ofthat agreement. As provided by paragraph (e)(2) ofthis section, W must capitalize its $7,000 payment tooutside counsel notwithstanding the fact that W madeno payment described in paragraph (d)(6)(i) of thissection.

Example 4. Costs to facilitate. U corporation,which owns a majority of the common stock of Tcorporation, votes its controlling interest in favor ofa perpetual extension of T’s charter. M, a minorityshareholder in T, votes against the extension. Un-der applicable state law, U is required to purchase thestock of T held by M. When U and M are unable toagree on the value of M’s shares, U brings an actionin state court to appraise the value of M’s stock inter-est. U pays attorney, accountant and appraisal fees of$25,000 for services rendered in connection with thenegotiation and litigation with M. Because U’s attor-ney, accountant and appraisal costs help establish thepurchase price of M’s stock, U’s $25,000 paymentfacilitates the acquisition of stock. Accordingly, Umust capitalize the $25,000 payment under paragraph(b)(1)(v) of this section.

Example 5. Costs to facilitate. For several years,H corporation has provided services to J corporationwhenever requested by J. H wants to enter into a mul-tiple-year contract with J that would give H the rightto provide services to J. On June 10, 2004, H startsto prepare a bid to provide services to J and paysa consultant $15,000 to research potential competi-tors. On August 10, 2004, H raises the possibility ofa multi-year contract with J. On October 10, 2004,H and J enter into a contract giving H the right toprovide services to J for five years. During 2004, Hpays $7,000 to travel to the city in which J’s officesare located to continue providing services to J undertheir prior arrangement and pays $6,000 for travel tothe city in which J’s offices are located to further de-velop H’s business relationship with J (for example,to introduce new employees, update J on current de-velopments and take J’s executives to dinner). H alsopays $8,000 for travel costs to meet with J to discussand negotiate the contract. Because the contract givesH the right to provide services to J, H must capital-ize amounts paid to facilitate the creation of the con-tract. The $7,000 of travel expenses paid to provideservices to J under their prior arrangement does notfacilitate the creation of the contract and is not re-quired to be capitalized, regardless of when the traveloccurs. The $6,000 of travel expenses paid to fur-ther develop H’s business relationship with J is paidin the process of pursuing the contract (and thereforemust be capitalized) only to the extent the expensesrelate to travel on or after June 10, 2004 (the date Hbegins to prepare a bid), and before October 11, 2004(the date after H and J enter into the contract). The$8,000 of travel expenses paid to meet with J to dis-cuss and negotiate the contract is paid in the processof pursuing the contact and must be capitalized. The$15,000 of consultant fees is paid to investigate thecontract and also must be capitalized.

Example 6. Costs that do not facilitate. X cor-poration brings a legal action against Y corporation

to recover lost profits resulting from Y’s alleged in-fringement of X’s copyright. Y does not challengeX’s copyright, but argues that it did not infringe uponX’s copyright. X pays its outside counsel $25,000 forlegal services rendered in pursuing the suit against Y.Because X’s title to its copyright is not in question,X’s action against Y does not involve X’s defenseor perfection of title to intangible property. Thus,the amount paid to outside counsel does not facilitatethe creation of an intangible described in paragraph(d)(9) of this section. Accordingly, X is not requiredto capitalize its $25,000 payment under this section.

Example 7. De minimis rule. W corporation, acommercial bank, acquires a portfolio containing 100loans from Y corporation. As part of the acquisition,W pays an independent appraiser a fee of $10,000 toappraise the portfolio. The fee is an amount paid tofacilitate W’s acquisition of an intangible. The ac-quisition of the loan portfolio is a single transactionwithin the meaning of paragraph (e)(3) of this section.Because the amount paid to facilitate the transactionexceeds $5,000, the amount is not de minimis as de-fined in paragraph (e)(4)(iii)(A) of this section. Ac-cordingly, W must capitalize the $10,000 fee underparagraph (b)(1)(v) of this section.

Example 8. Compensation and overhead. P cor-poration, a commercial bank, maintains a loan acqui-sition department whose sole function is to acquireloans from other financial institutions. As providedin paragraph (e)(4)(i) of this section, P is not requiredto capitalize any portion of the compensation paid tothe employees in its loan acquisition department orany portion of its overhead allocable to the loan ac-quisition department.

(f) 12-month rule — (1) In general. Ex-cept as otherwise provided in this para-graph (f), a taxpayer is not required to cap-italize under this section amounts paid tocreate (or to facilitate the creation of) anyright or benefit for the taxpayer that doesnot extend beyond the earlier of —

(i) 12 months after the first date onwhich the taxpayer realizes the right orbenefit; or

(ii) The end of the taxable year follow-ing the taxable year in which the paymentis made.

(2) Duration of benefit for contract ter-minations. For purposes of this paragraph(f), amounts paid to terminate a contractor other agreement described in paragraph(d)(7)(i) of this section prior to its expira-tion date (or amounts paid to facilitate suchtermination) create a benefit for the tax-payer that lasts for the unexpired term ofthe agreement immediately before the dateof the termination. If the terms of a con-tract or other agreement described in para-graph (d)(7)(i) of this section permit thetaxpayer to terminate the contract or agree-ment after a notice period, amounts paidby the taxpayer to terminate the contractor agreement before the end of the notice

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period create a benefit for the taxpayer thatlasts for the amount of time by which thenotice period is shortened.

(3) Inapplicability to created financialinterests and self-created amortizable sec-tion 197 intangibles. Paragraph (f)(1) ofthis section does not apply to amounts paidto create (or facilitate the creation of) anintangible described in paragraph (d)(2) ofthis section (relating to amounts paid tocreate financial interests) or to amountspaid to create (or facilitate the creationof) an intangible that constitutes an amor-tizable section 197 intangible within themeaning of section 197(c).

(4) Inapplicability to rights of indefiniteduration. Paragraph (f)(1) of this sectiondoes not apply to amounts paid to create(or facilitate the creation of) an intangibleof indefinite duration. A right has an in-definite duration if it has no period of du-ration fixed by agreement or by law, or ifit is not based on a period of time, such asa right attributable to an agreement to pro-vide or receive a fixed amount of goods orservices. For example, a license grantedby a governmental agency that permits thetaxpayer to operate a business conveys aright of indefinite duration if the licensemay be revoked only upon the taxpayer’sviolation of the terms of the license.

(5) Rights subject to renewal — (i) Ingeneral. For purposes of paragraph (f)(1)of this section, the duration of a right in-cludes any renewal period if all of thefacts and circumstances in existence dur-ing the taxable year in which the right iscreated indicate a reasonable expectancyof renewal.

(ii) Reasonable expectancy of renewal.The following factors are significant in de-termining whether there exists a reason-able expectancy of renewal:

(A) Renewal history. The fact that sim-ilar rights are historically renewed is ev-idence of a reasonable expectancy of re-newal. On the other hand, the fact that sim-ilar rights are rarely renewed is evidenceof a lack of a reasonable expectancy of re-newal. Where the taxpayer has no experi-ence with similar rights, or where the tax-payer holds similar rights only occasion-ally, this factor is less indicative of a rea-sonable expectancy of renewal.

(B) Economics of the transaction. Thefact that renewal is necessary for thetaxpayer to earn back its investment inthe right is evidence of a reasonable ex-

pectancy of renewal. For example, if ataxpayer pays $14,000 to enter into a re-newable contract with an initial 9-monthterm that is expected to generate incometo the taxpayer of $1,000 per month, thefact that renewal is necessary for the tax-payer to earn back its $14,000 paymentis evidence of a reasonable expectancy ofrenewal.

(C) Likelihood of renewal by otherparty. Evidence that indicates a likelihoodof renewal by the other party to a right,such as a bargain renewal option or similararrangement, is evidence of a reasonableexpectancy of renewal. However, themere fact that the other party will have theopportunity to renew on the same terms asare available to others is not evidence of areasonable expectancy of renewal.

(D) Terms of renewal. The fact thatmaterial terms of the right are subject torenegotiation at the end of the initial termis evidence of a lack of a reasonable ex-pectancy of renewal. For example, if theparties to an agreement must renegotiateprice or amount, the renegotiation require-ment is evidence of a lack of a reasonableexpectancy of renewal.

(E) Terminations. The fact that similarrights are typically terminated prior to re-newal is evidence of a lack of a reasonablyexpectancy of renewal.

(iii) Safe harbor pooling method. Inlieu of applying the reasonable expectancyof renewal test described in paragraph(f)(5)(ii) of this section to each separateright created during a taxable year, a tax-payer that reasonably expects to enter intoat least 25 similar rights during the taxableyear may establish a pool of similar rightsfor which the initial term does not extendbeyond the period prescribed in paragraph(f)(1) of this section and may elect to ap-ply the reasonable expectancy of renewaltest to that pool. See paragraph (h) ofthis section for additional rules relatingto pooling. The application of paragraph(f)(1) of this section to each pool is deter-mined in the following manner:

(A) All amounts (except de minimiscosts described in paragraph (d)(6)(v) ofthis section) paid to create the rights in-cluded in the pool and all amounts paid tofacilitate the creation of the rights includedin the pool are aggregated.

(B) If less than 20 percent of the rightsin the pool are reasonably expected to berenewed beyond the period prescribed in

paragraph (f)(1) of this section, all rightsin the pool are treated as having a durationthat does not extend beyond the period pre-scribed in paragraph (f)(1) of this section,and the taxpayer is not required to capital-ize under this section any portion of theaggregate amount described in paragraph(f)(5)(iii)(A) of this section.

(C) If more than 80 percent of the rightsin the pool are reasonably expected to berenewed beyond the period prescribed inparagraph (f)(1) of this section, all rightsin the pool are treated as having a durationthat extends beyond the period prescribedin paragraph (f)(1) of this section, and thetaxpayer is required to capitalize under thissection the aggregate amount described inparagraph (f)(5)(iii)(A) of this section.

(D) If 20 percent or more, but 80 per-cent or less, of the rights in the pool arereasonably expected to be renewed beyondthe period prescribed in paragraph (f)(1)of this section, the aggregate amount de-scribed in paragraph (f)(5)(iii)(A) of thissection is multiplied by the percentage ofthe rights in the pool that are reasonablyexpected to be renewed beyond the pe-riod prescribed in paragraph (f)(1) of thissection and the taxpayer must capitalizethe resulting amount under this section bytreating such amount as creating a sepa-rate intangible. The amount determinedby multiplying the aggregate amount de-scribed in paragraph (f)(5)(iii)(A) of thissection by the percentage of rights in thepool that are not reasonably expected to berenewed beyond the period prescribed inparagraph (f)(1) of this section is not re-quired to be capitalized under this section.

(6) Coordination with section 461. Inthe case of a taxpayer using an accrualmethod of accounting, the rules of thisparagraph (f) do not affect the determi-nation of whether a liability is incurredduring the taxable year, including the de-termination of whether economic perfor-mance has occurred with respect to the li-ability. See §1.461–4 for rules relating toeconomic performance.

(7) Election to capitalize. A taxpayermay elect not to apply the rule containedin paragraph (f)(1) of this section. Anelection made under this paragraph (f)(7)applies to all similar transactions duringthe taxable year to which paragraph (f)(1)of this section would apply (but for theelection under this paragraph (f)(7)). Forexample, a taxpayer may elect under this

February 17, 2004 466 2004-7 I.R.B.

paragraph (f)(7) to capitalize its costsof prepaying insurance contracts for 12months, but may continue to apply therule in paragraph (f)(1) to its costs ofentering into non-renewable, 12-monthservice contracts. A taxpayer makes theelection by treating the amounts as capitalexpenditures in its timely filed originalfederal income tax return (including ex-tensions) for the taxable year during whichthe amounts are paid. In the case of anaffiliated group of corporations filing aconsolidated return, the election is madeseparately with respect to each memberof the group, and not with respect to thegroup as a whole. In the case of an Scorporation or partnership, the electionis made by the S corporation or by thepartnership, and not by the shareholdersor partners. An election made under thisparagraph (f)(7) is revocable with respectto each taxable year for which made onlywith the consent of the Commissioner.

(8) Examples. The rules of this para-graph (f) are illustrated by the followingexamples, in which it is assumed (unlessotherwise stated) that the taxpayer is a cal-endar year, accrual method taxpayer thatdoes not have a short taxable year in anytaxable year and has not made an electionunder paragraph (f)(7) of this section:

Example 1. Prepaid expenses. On December 1,2005, N corporation pays a $10,000 insurance pre-mium to obtain a property insurance policy (with nocash value) with a 1-year term that begins on Feb-ruary 1, 2006. The amount paid by N is a prepaidexpense described in paragraph (d)(3) of this sectionand not paragraph (d)(2) of this section. Because theright or benefit attributable to the $10,000 paymentextends beyond the end of the taxable year followingthe taxable year in which the payment is made, the12-month rule provided by this paragraph (f) does notapply. N must capitalize the $10,000 payment.

Example 2. Prepaid expenses. (i) Assume thesame facts as in Example 1, except that the policyhas a term beginning on December 15, 2005. The12-month rule of this paragraph (f) applies to the$10,000 payment because the right or benefit attrib-utable to the payment neither extends more than 12months beyond December 15, 2005 (the first date thebenefit is realized by the taxpayer), nor beyond theend of the taxable year following the taxable year inwhich the payment is made. Accordingly, N is notrequired to capitalize the $10,000 payment.

(ii) Alternatively, assume N capitalizes prepaidexpenses for financial accounting and reporting pur-poses and elects under paragraph (f)(7) of this sectionnot to apply the 12-month rule contained in paragraph(f)(1) of this section. N must capitalize the $10,000payment for federal income tax purposes.

Example 3. Financial interests. On October 1,2005, X corporation makes a 9-month loan to B in theprincipal amount of $250,000. The principal amount

of the loan to B constitutes an amount paid to cre-ate or originate a financial interest under paragraph(d)(2)(i)(B) of this section. The 9-month term of theloan does not extend beyond the period prescribed byparagraph (f)(1) of this section. However, as pro-vided by paragraph (f)(3) of this section, the rulesof this paragraph (f) do not apply to intangibles de-scribed in paragraph (d)(2) of this section. Accord-ingly, X must capitalize the $250,000 loan amount.

Example 4. Financial interests. X corporationowns all of the outstanding stock of Z corpora-tion. On December 1, 2005, Y corporation pays X$1,000,000 in exchange for X’s grant of a 9-monthcall option to Y permitting Y to purchase all of theoutstanding stock of Z. Y’s payment to X constitutesan amount paid to create or originate an option withX under paragraph (d)(2)(i)(C)(7) of this section.The 9-month term of the option does not extendbeyond the period prescribed by paragraph (f)(1) ofthis section. However, as provided by paragraph(f)(3) of this section, the rules of this paragraph (f)do not apply to intangibles described in paragraph(d)(2) of this section. Accordingly, Y must capitalizethe $1,000,000 payment.

Example 5. License. (i) On July 1, 2005, R cor-poration pays $10,000 to state X to obtain a license tooperate a business in state X for a period of 5 years.The terms of the license require R to pay state X anannual fee of $500 due on July 1, 2005, and each ofthe succeeding four years. R pays the $500 fee onJuly 1 as required by the license.

(ii) R’s payment of $10,000 is an amount paid toa governmental agency for a license granted by thatagency to which paragraph (d)(5) of this section ap-plies. Because R’s payment creates rights or benefitsfor R that extend beyond 12 months after the first dateon which R realizes the rights or benefits attributableto the payment and beyond the end of 2006 (the tax-able year following the taxable year in which the pay-ment is made), the rules of this paragraph (f) do notapply to R’s payment. Accordingly, R must capital-ize the $10,000 payment.

(iii) R’s payment of each $500 annual fee is aprepaid expense described in paragraph (d)(3) of thissection. R is not required to capitalize the $500 feein each taxable year. The rules of this paragraph (f)apply to each such payment because each paymentprovides a right or benefit to R that does not extendbeyond 12 months after the first date on which R real-izes the rights or benefits attributable to the paymentand does not extend beyond the end of the taxableyear following the taxable year in which the paymentis made.

Example 6. Lease. On December 1, 2005, W cor-poration enters into a lease agreement with X corpo-ration under which W agrees to lease property to Xfor a period of 9 months, beginning on December 1,2005. W pays its outside counsel $7,000 for legalservices rendered in drafting the lease agreement andnegotiating with X. The agreement between W andX is an agreement providing W the right to be com-pensated for the use of property, as described in para-graph (d)(6)(i)(A) of this section. W’s $7,000 pay-ment to its outside counsel is an amount paid to fa-cilitate W’s creation of the lease as described in para-graph (e)(1)(i) of this section. The 12-month rule ofthis paragraph (f) applies to the $7,000 payment be-cause the right or benefit that the $7,000 payment fa-cilitates the creation of neither extends more than 12

months beyond December 1, 2005 (the first date thebenefit is realized by the taxpayer), nor beyond theend of the taxable year following the taxable year inwhich the payment is made. Accordingly, W is notrequired to capitalize its payment to its outside coun-sel.

Example 7. Certain contract terminations. V cor-poration owns real property that it has leased to A fora period of 15 years. When the lease has a remainingunexpired term of 5 years, V and A agree to termi-nate the lease, enabling V to use the property in itstrade or business. V pays A $100,000 in exchangefor A’s agreement to terminate the lease. V’s paymentto A to terminate the lease is described in paragraph(d)(7)(i)(A) of this section. Under paragraph (f)(2) ofthis section, V’s payment creates a benefit for V witha duration of 5 years, the remaining unexpired termof the lease as of the date of the termination. Becausethe benefit attributable to the expenditure extends be-yond 12 months after the first date on which V real-izes the rights or benefits attributable to the paymentand beyond the end of the taxable year following thetaxable year in which the payment is made, the rulesof this paragraph (f) do not apply to the payment. Vmust capitalize the $100,000 payment.

Example 8. Certain contract terminations. As-sume the same facts as in Example 7, except that thelease is terminated when it has a remaining unexpiredterm of 10 months. Under paragraph (f)(2) of thissection, V’s payment creates a benefit for V with aduration of 10 months. The 12-month rule of thisparagraph (f) applies to the payment because the ben-efit attributable to the payment neither extends morethan 12 months beyond the date of termination (thefirst date the benefit is realized by V) nor beyond theend of the taxable year following the taxable year inwhich the payment is made. Accordingly, V is notrequired to capitalize the $100,000 payment.

Example 9. Certain contract terminations. As-sume the same facts as in Example 7, except that ei-ther party can terminate the lease upon 12 months no-tice. When the lease has a remaining unexpired termof 5 years, V wants to terminate the lease, however,V does not want to wait another 12 months. V paysA $50,000 for the ability to terminate the lease withone month’s notice. V’s payment to A to terminatethe lease is described in paragraph (d)(7)(i)(A) of thissection. Under paragraph (f)(2) of this section, V’spayment creates a benefit for V with a duration of 11months, the time by which the notice period is short-ened. The 12-month rule of this paragraph (f) appliesto V’s $50,000 payment because the benefit attrib-utable to the payment neither extends more than 12months beyond the date of termination (the first datethe benefit is realized by V) nor beyond the end of thetaxable year following the taxable year in which thepayment is made. Accordingly, V is not required tocapitalize the $50,000 payment.

Example 10. Coordination with section 461. (i) Ucorporation leases office space from W corporation ata monthly rental rate of $2,000. On August 1, 2005, Uprepays its office rent expense for the first six monthsof 2006 in the amount of $12,000. For purposes ofthis example, it is assumed that the recurring itemexception provided by §1.461–5 does not apply andthat the lease between W and U is not a section 467rental agreement as defined in section 467(d).

(ii) Under §1.461–4(d)(3), U’s prepayment ofrent is a payment for the use of property by U for

2004-7 I.R.B. 467 February 17, 2004

which economic performance occurs ratably overthe period of time U is entitled to use the property.Accordingly, because economic performance withrespect to U’s prepayment of rent does not occuruntil 2006, U’s prepaid rent is not incurred in 2005and therefore is not properly taken into accountthrough capitalization, deduction, or otherwise in2005. Thus, the rules of this paragraph (f) do notapply to U’s prepayment of its rent.

(iii) Alternatively, assume that U uses the cashmethod of accounting and the economic performancerules in §1.461–4 therefore do not apply to U. The12-month rule of this paragraph (f) applies to the$12,000 payment because the rights or benefits at-tributable to U’s prepayment of its rent do not extendbeyond December 31, 2006. Accordingly, U is notrequired to capitalize its prepaid rent.

Example 11. Coordination with section 461. Ncorporation pays R corporation, an advertising andmarketing firm, $40,000 on August 1, 2005, for ad-vertising and marketing services to be provided toN throughout calendar year 2006. For purposes ofthis example, it is assumed that the recurring item ex-ception provided by §1.461–5 does not apply. Under§1.461–4(d)(2), N’s payment arises out of the provi-sion of services to N by R for which economic perfor-mance occurs as the services are provided. Accord-ingly, because economic performance with respect toN’s prepaid advertising expense does not occur until2006, N’s prepaid advertising expense is not incurredin 2005 and therefore is not properly taken into ac-count through capitalization, deduction, or otherwisein 2005. Thus, the rules of this paragraph (f) do notapply to N’s payment.

(g) Treatment of capitalized costs — (1)In general. An amount required to be cap-italized by this section is not currently de-ductible under section 162. Instead, theamount generally is added to the basis ofthe intangible acquired or created. See sec-tion 1012.

(2) Financial instruments. In the caseof a financial instrument described in para-graph (c)(1)(iii) or (d)(2)(i)(C) of this sec-tion, notwithstanding paragraph (g)(1) ofthis section, if under other provisions oflaw the amount required to be capitalizedis not required to be added to the basis ofthe intangible acquired or created, then theother provisions of law will govern the taxtreatment of the amount.

(h) Special rules applicable to pooling— (1) In general. Except as otherwise pro-vided, the rules of this paragraph (h) ap-ply to the pooling methods described inparagraph (d)(6)(v) of this section (relatingto de minimis rules applicable to certaincontract rights), paragraph (e)(4)(iii)(A) ofthis section (relating to de minimis rulesapplicable to transaction costs), and para-graph (f)(5)(iii) of this section (relating tothe application of the 12-month rule to re-newable rights).

(2) Method of accounting. A pool-ing method authorized by this section con-stitutes a method of accounting for pur-poses of section 446. A taxpayer thatadopts or changes to a pooling methodauthorized by this section must use themethod for the year of adoption and forall subsequent taxable years during whichthe taxpayer qualifies to use the poolingmethod unless a change to another methodis required by the Commissioner in orderto clearly reflect income, or unless per-mission to change to another method isgranted by the Commissioner as providedin §1.446–1(e).

(3) Adopting or changing to a poolingmethod. A taxpayer adopts (or changes to)a pooling method authorized by this sec-tion for any taxable year by establishingone or more pools for the taxable year inaccordance with the rules governing theparticular pooling method and the rulesprescribed by this paragraph (h), and byusing the pooling method to compute itstaxable income for the year of adoption (orchange).

(4) Definition of pool. A taxpayer mayuse any reasonable method of defining apool of similar transactions, agreements orrights, including a method based on thetype of customer or the type of product orservice provided under a contract. How-ever, a taxpayer that pools similar trans-actions, agreements or rights must includein the pool all similar transactions, agree-ments or rights created during the taxableyear. For purposes of the pooling meth-ods described in paragraph (d)(6)(v) of thissection (relating to de minimis rules appli-cable to certain contract rights) and para-graph (e)(4)(iii)(A) of this section (relat-ing to de minimis rules applicable to trans-action costs), an agreement (or a trans-action) is treated as not similar to otheragreements (or transactions) included inthe pool if the amount at issue with re-spect to that agreement (or transaction) isreasonably expected to differ significantlyfrom the average amount at issue with re-spect to the other agreements (or transac-tions) properly included in the pool.

(5) Consistency requirement. A tax-payer that uses the pooling method de-scribed in paragraph (f)(5)(iii) of this sec-tion for purposes of applying the 12-monthrule to a right or benefit —

(i) Must use the pooling methods de-scribed in paragraph (d)(6)(v) of this sec-

tion (relating to de minimis rules appli-cable to certain contract rights) and para-graph (e)(4)(iii)(A) of this section (relatingto de minimis rules applicable to transac-tion costs) for purposes of determining theamount paid to create, or facilitate the cre-ation of, the right or benefit; and

(ii) Must use the same pool for purposesof paragraph (d)(6)(v) of this section andparagraph (e)(4)(iii)(A) of this section asis used for purposes of paragraph (f)(5)(iii)of this section.

(6) Additional guidance pertaining topooling. The Internal Revenue Servicemay publish guidance in the Internal Rev-enue Bulletin (see §601.601(d)(2) of thischapter) prescribing additional rules forapplying the pooling methods authorizedby this section to specific industries or tospecific types of transactions.

(7) Example. The following exampleillustrates the rules of this paragraph (h):

Example. Pooling. (i) In the course of its busi-ness, W corporation enters into 3-year non-cancelablecontracts that provide W the right to provide servicesto its customers. W generally pays certain amounts inthe process of pursuing an agreement with a customer,including amounts paid to credit reporting agencies toverify the credit history of the potential customer andcommissions paid to the independent sales agent whosecures the agreement with the customer. In the caseof agreements that W enters into with customers whoare individuals, the agreements contain substantiallysimilar terms and conditions and W typically paysbetween $100 and $200 in the process of pursuingeach transaction. During 2005, W enters into agree-ments with 300 individuals. Also during 2005, Wenters into an agreement with X corporation contain-ing terms and conditions that are substantially simi-lar to those contained in the agreements W enters intowith its customers who are individuals. W pays cer-tain amounts in the process of pursuing the agreementwith X that W would not typically incur in the processof pursuing an agreement with its customers who areindividuals. For example, W pays amounts to pre-pare and submit a bid for the agreement with X andamounts to travel to X’s headquarters to make a salespresentation to X’s management. In the aggregate, Wpays $11,000 in the process of obtaining the agree-ment with X.

(ii) The agreements between W and its customersare agreements providing W the right to provide ser-vices, as described in paragraph (d)(6)(i)(B) of thissection. Under paragraph (b)(1)(v) of this section,W must capitalize transaction costs paid to facilitatethe creation of these agreements. Because W entersinto at least 25 similar transactions during 2005, Wmay pool its transactions for purposes of determiningwhether its transaction costs are de minimis within themeaning of paragraph (e)(4)(iii)(A) of this section. Wadopts a pooling method by establishing one or morepools of similar transactions and by using the poolingmethod to compute its taxable income beginning inits 2005 taxable year. If W adopts a pooling method,W must include all similar transactions in the pool.

February 17, 2004 468 2004-7 I.R.B.

Under paragraph (h)(4) of this section, the transac-tion with X is not similar to the transactions W entersinto with its customers who are individuals. Whilethe agreement with X contains terms and conditionsthat are substantially similar to those contained in theagreements W enters into with its customers who areindividuals, the transaction costs paid in the processof pursuing the agreement with X are reasonably ex-pected to differ significantly from the average trans-action costs attributable to transactions with its cus-tomers who are individuals. Accordingly, W may notinclude the transaction with X in the pool of transac-tions with customers who are individuals.

(i) [Reserved].(j) Application to accrual method tax-

payers. For purposes of this section,the terms amount paid and paymentmean, in the case of a taxpayer usingan accrual method of accounting, a li-ability incurred (within the meaning of§1.446–1(c)(1)(ii)). A liability may notbe taken into account under this sectionprior to the taxable year during which theliability is incurred.

(k) Treatment of related parties and in-direct payments. For purposes of this sec-tion, references to a party other than thetaxpayer include persons related to thatparty and persons acting for or on behalf ofthat party (including persons to whom thetaxpayer becomes obligated as a result ofassuming a liability of that party). For thispurpose, persons are related only if theirrelationship is described in section 267(b)or 707(b) or they are engaged in trades orbusinesses under common control withinthe meaning of section 41(f)(1). Refer-ences to an amount paid to or by a partyinclude an amount paid on behalf of thatparty.

(l) Examples. The rules of this sec-tion are illustrated by the following exam-ples in which it is assumed that the In-ternal Revenue Service has not publishedguidance that requires capitalization underparagraph (b)(1)(iv) of this section (relat-ing to amounts paid to create or enhance afuture benefit that is identified in publishedguidance as an intangible for which capi-talization is required):

Example 1. License granted by a governmentalunit. (i) X corporation pays $25,000 to state R to ob-tain a license to sell alcoholic beverages in its restau-rant. The license is valid indefinitely, provided Xcomplies with all applicable laws regarding the saleof alcoholic beverages in state R. X pays its outsidecounsel $4,000 for legal services rendered in prepar-ing the license application and otherwise representingX during the licensing process. In addition, X deter-mines that $2,000 of salaries paid to its employeesis allocable to services rendered by the employees inobtaining the license.

(ii) X’s payment of $25,000 is an amount paid to agovernmental unit to obtain a license granted by thatagency, as described in paragraph (d)(5)(i) of this sec-tion. The right has an indefinite duration and consti-tutes an amortizable section 197 intangible. Accord-ingly, as provided in paragraph (f)(3) of this section,the provisions of paragraph (f) of this section (relatingto the 12-month rule) do not apply to X’s payment. Xmust capitalize its $25,000 payment to obtain the li-cense from state R.

(iii) As provided in paragraph (e)(4) of thissection, X is not required to capitalize employeecompensation because such amounts are treatedas amounts that do not facilitate the acquisition orcreation of an intangible. Thus, X is not requiredto capitalize the $2,000 of employee compensationallocable to the transaction.

(iv) X’s payment of $4,000 to its outside coun-sel is an amount paid to facilitate the creation of anintangible, as described in paragraph (e)(1)(i) of thissection. Because X’s transaction costs do not exceed$5,000, X’s transaction costs are de minimis withinthe meaning of paragraph (e)(4)(iii)(A) of this sec-tion. Accordingly, X is not required to capitalize the$4,000 payment to its outside counsel under this sec-tion.

Example 2. Franchise agreement. (i) R corpo-ration is a franchisor of income tax return prepara-tion outlets. V corporation negotiates with R to ob-tain the right to operate an income tax return prepa-ration outlet under a franchise from R. V pays an ini-tial $100,000 franchise fee to R in exchange for thefranchise agreement. In addition, V pays its outsidecounsel $4,000 to represent V during the negotiationswith R. V also pays $2,000 to an industry consultantto advise V during the negotiations with R.

(ii) Under paragraph (d)(6)(i)(A) of this section,V’s payment of $100,000 is an amount paid to anotherparty to enter into an agreement with that party pro-viding V the right to use tangible or intangible prop-erty. Accordingly, V must capitalize its $100,000payment to R. The franchise agreement is a self-cre-ated amortizable section 197 intangible within themeaning of section 197(c). Accordingly, as providedin paragraph (f)(3) of this section, the 12-month rulecontained in paragraph (f)(1) of this section does notapply.

(iii) V’s payment of $4,000 to its outside coun-sel and $2,000 to the industry consultant are amountspaid to facilitate the creation of an intangible, as de-scribed in paragraph (e)(1)(i) of this section. BecauseV’s aggregate transaction costs exceed $5,000, V’stransaction costs are not de minimis within the mean-ing of paragraph (e)(4)(iii)(A) of this section. Ac-cordingly, V must capitalize the $4,000 payment toits outside counsel and the $2,000 payment to the in-dustry consultant under this section into the basis ofthe franchise, as provided in paragraph (g) of this sec-tion.

Example 3. Covenant not to compete. (i) On De-cember 1, 2005, N corporation, a calendar year tax-payer, enters into a covenant not to compete with B,a key employee that is leaving the employ of N. Thecovenant not to compete is not entered into in con-nection with the acquisition of an interest in a tradeor business. The covenant not to compete prohibitsB from competing with N for a period of 9 months,beginning December 1, 2005. N pays B $25,000 infull consideration for B’s agreement not to compete.

In addition, N pays its outside counsel $6,000 to fa-cilitate the creation of the covenant not to competewith B. N does not have a short taxable year in 2005or 2006.

(ii) Under paragraph (d)(6)(i)(C) of this section,N’s payment of $25,000 is an amount paid to anotherparty to induce that party to enter into a covenant notto compete with N. However, because the covenantnot to compete has a duration that does not extendbeyond 12 months after the first date on which N re-alizes the rights attributable to its payment (i.e., De-cember 1, 2005) or beyond the end of the taxable yearfollowing the taxable year in which payment is made,the 12-month rule contained in paragraph (f)(1) ofthis section applies. Accordingly, N is not requiredto capitalize its $25,000 payment to B or its $6,000payment to facilitate the creation of the covenant notto compete.

Example 4. Demand-side management. (i) X cor-poration, a public utility engaged in generating anddistributing electrical energy, provides programs toits customers to promote energy conservation and en-ergy efficiency. These programs are aimed at reduc-ing electrical costs to X’s customers, building good-will with X’s customers, and reducing X’s future op-erating and capital costs. X provides these programswithout obligating any of its customers participat-ing in the programs to purchase power from X inthe future. Under these programs, X pays a consul-tant to help industrial customers design energy-effi-cient manufacturing processes, to conduct “energy ef-ficiency audits” that serve to identify for customersinefficiencies in their energy usage patterns, and toprovide cash allowances to encourage residential cus-tomers to replace existing appliances with more en-ergy efficient appliances.

(ii) The amounts paid by X to the consultant arenot amounts to acquire or create an intangible underparagraph (c) or (d) of this section or to facilitate suchan acquisition or creation. In addition, the amountsdo not create a separate and distinct intangible assetwithin the meaning of paragraph (b)(3) of this sec-tion. Accordingly, the amounts paid to the consultantare not required to be capitalized under this section.While the amounts may serve to reduce future oper-ating and capital costs and create goodwill with cus-tomers, these benefits, without more, are not intan-gibles for which capitalization is required under thissection.

Example 5. Business process re-engineering. (i)V corporation manufactures its products using a batchproduction system. Under this system, V continu-ously produces component parts of its various prod-ucts and stockpiles these parts until they are neededin V’s final assembly line. Finished goods are stock-piled awaiting orders from customers. V discoversthat this process ties up significant amounts of V’scapital in work-in-process and finished goods inven-tories. V hires B, a consultant, to advise V on improv-ing the efficiency of its manufacturing operations. Brecommends a complete re-engineering of V’s man-ufacturing process to a process known as just-in-timemanufacturing. Just-in-time manufacturing involvesreconfiguring a manufacturing plant to a configura-tion of “cells” where each team in a cell performsthe entire manufacturing process for a particular cus-tomer order, thus reducing inventory stockpiles.

(ii) V incurred three categories of costs to con-vert its manufacturing process to a just-in-time sys-

2004-7 I.R.B. 469 February 17, 2004

tem. First, V paid B, a consultant, $250,000 in profes-sional fees to implement the conversion of V’s plantto a just-in-time system. Second, V paid C, a contrac-tor, $100,000 to relocate and reconfigure V’s manu-facturing equipment from an assembly line layout to aconfiguration of cells. Third, V paid D, a consultant,$50,000 to train V’s employees in the just-in-timemanufacturing process.

(iii) The amounts paid by V to B, C, and D arenot amounts to acquire or create an intangible underparagraph (c) or (d) of this section or to facilitate suchan acquisition or creation. In addition, the amountsdo not create a separate and distinct intangible assetwithin the meaning of paragraph (b)(3) of this sec-tion. Accordingly, the amounts paid to B, C, and Dare not required to be capitalized under this section.While the amounts produce long term benefits to V inthe form of reduced inventory stockpiles, improvedproduct quality, and increased efficiency, these bene-fits, without more, are not intangibles for which cap-italization is required under this section.

Example 6. Defense of business reputation. (i)X, an investment adviser, serves as the fund managerof a money market investment fund. X, like its com-petitors in the industry, strives to maintain a constantnet asset value for its money market fund of $1.00per share. During 2005, in the course of managingthe fund assets, X incorrectly predicts the directionof market interest rates, resulting in significant in-vestment losses to the fund. Due to these significantlosses, X is faced with the prospect of reporting anet asset value that is less than $1.00 per share. Xis not aware of any investment adviser in its industrythat has ever reported a net asset value for its moneymarket fund of less than $1.00 per share. X is con-cerned that reporting a net asset value of less than$1.00 per share will significantly harm its reputationas an investment adviser, and could lead to litigationby shareholders. X decides to contribute $2,000,000to the fund in order to raise the net asset value of thefund to $1.00 per share. This contribution is not aloan to the fund and does not give X any ownershipinterest in the fund.

(ii) The $2,000,000 contribution is not an amountpaid to acquire or create an intangible under para-graph (c) or (d) of this section or to facilitate suchan acquisition or creation. In addition, the amountdoes not create a separate and distinct intangible as-set within the meaning of paragraph (b)(3) of this sec-tion. Accordingly, the amount contributed to the fundis not required to be capitalized under this section.While the amount serves to protect the business rep-utation of the taxpayer and may protect the taxpayerfrom litigation by shareholders, these benefits, with-out more, are not intangibles for which capitalizationis required under this section.

Example 7. Product launch costs. (i) R corpo-ration, a manufacturer of pharmaceutical products, isrequired by law to obtain regulatory approval beforeselling its products. While awaiting regulatory ap-proval on Product A, R pays to develop and imple-ment a marketing strategy and an advertising cam-paign to raise consumer awareness of the purportedneed for Product A. R also pays to train health careprofessionals and other distributors in the proper useof Product A.

(ii) The amounts paid by R are not amounts paidto acquire or create an intangible under paragraph (c)or (d) of this section or to facilitate such an acquisi-

tion or creation. In addition, the amounts do not cre-ate a separate and distinct intangible asset within themeaning of paragraph (b)(3) of this section. Accord-ingly, R is not required to capitalize these amountsunder this section. While the amounts may benefit Rby creating consumer demand for Product A and in-creasing awareness of Product A among distributors,these benefits, without more, are not intangibles forwhich capitalization is required under this section.

Example 8. Stocklifting costs. (i) N corporation isa wholesale distributor of Brand A aftermarket auto-mobile replacement parts. In an effort to induce a re-tail automobile parts supply store to stock only BrandA parts, N offers to replace all of the store’s inven-tory of other branded parts with Brand A parts, andto credit the store for its cost of other branded parts.The store is under no obligation to continue stockingBrand A parts or to purchase a minimum volume ofBrand A parts from N in the future.

(ii) The amount paid by N as a credit to the storefor the cost of other branded parts is not an amountpaid to acquire or create an intangible under para-graph (c) or (d) of this section or to facilitate suchan acquisition or creation. In addition, the amountdoes not create a separate and distinct intangible as-set within the meaning of paragraph (b)(3) of this sec-tion. Accordingly, N is not required to capitalize theamount under this section. While the amount maycreate a hope or expectation by N that the store willcontinue to stock Brand A parts, this benefit, withoutmore, is not an intangible for which capitalization isrequired under this section.

(iii) Alternatively, assume that N agrees to creditthe store for its cost of other branded parts in ex-change for the store’s agreement to purchase all ofits inventory requirements for such parts from N fora period of at least 3 years. The amount paid by N asa credit to the store for the cost of other branded partsis an amount paid to induce the store to enter into anagreement providing R the right to provide property.Accordingly, R must capitalize its payment.

Example 9. Package design costs. (i) Z corpo-ration manufactures and markets personal care prod-ucts. Z pays $100,000 to a consultant to develop apackage design for Z’s newest product, Product A.Z also pays a fee to a government agency to obtaintrademark and copyright protection on certain ele-ments of the package design. Z pays its outside le-gal counsel $10,000 for services rendered in prepar-ing and filing the trademark and copyright applica-tions and for other services rendered in securing thetrademark and copyright protection.

(ii) The $100,000 paid by Z to the consultant fordevelopment of the package design is not an amountpaid to acquire or create an intangible under para-graph (c) or (d) of this section or to facilitate suchan acquisition or creation. In addition, as providedin paragraph (b)(3)(v) of this section, amounts paidto develop a package design are treated as amountsthat do not create a separate and distinct intangibleasset. Accordingly, Z is not required to capitalize the$100,000 payment under this section.

(iii) The amounts paid by Z to the governmentagency to obtain trademark and copyright protectionare amounts paid to a government agency for a rightgranted by that agency. Accordingly, Z must capital-ize the payment. In addition, the $10,000 paid by Zto its outside counsel is an amount paid to facilitatethe creation of the trademark and copyright. Because

the aggregate amounts paid to facilitate the transac-tion exceed $5,000, the amounts are not de minimisas defined in paragraph (e)(4)(iii)(A) of this section.Accordingly, Z must capitalize the $10,000 paymentto its outside counsel under paragraph (b)(1)(v) of thissection.

(iv) Alternatively, assume that Z acquires an ex-isting package design for Product A as part of an ac-quisition of a trade or business that constitutes an ap-plicable asset acquisition within the meaning of sec-tion 1060(c). Assume further that $100,000 of theconsideration paid by N in the acquisition is properlyallocable to the package design for Product A. Underparagraph (c)(1) of this section, Z must capitalize the$100,000 payment.

Example 10. Contract to provide services. (i) Qcorporation, a financial planning firm, provides fi-nancial advisory services on a fee-only basis. During2005, Q and several other financial planning firmssubmit separate bids to R corporation for a contractto become one of three providers of financial advi-sory services to R’s employees. Q pays $2,000 toa printing company to develop and produce materi-als for its sales presentation to R’s management. Qalso pays $6,000 to travel to R’s corporate headquar-ters to make the sales presentation, and $20,000 ofsalaries to its employees for services performed inpreparing the bid and making the presentation to R’smanagement. Q’s bid is successful and Q enters intoan agreement with R in 2005 under which Q agreesto provide financial advisory services to R’s employ-ees, and R agrees to pay Q’s fee on behalf of eachemployee who chooses to utilize such services. R en-ters into similar agreements with two other financialplanning firms, and R’s employees may choose to usethe services of any one of the three firms. Based onits past experience, Q reasonably expects to provideservices to at least 5 percent of R’s employees.

(ii) Q’s agreement with R is not an agreement pro-viding Q the right to provide services, as describedin paragraph (d)(6)(i)(B) of this section. Under para-graph (d)(6)(iv) the agreement places no obligationon another person to request or pay for Q’s services.Accordingly, Q is not required to capitalize any of theamounts paid in the process of pursuing the agree-ment with R.

Example 11. Mutual fund distributor. (i) D in-curs costs to enter into a distribution agreement withM, a mutual fund. The initial term of the distribu-tion agreement is two years, and afterwards must beapproved annually by M. The distribution agreementcan be terminated by either party on 60 days notice.Although distribution agreements are rarely termi-nated in the mutual fund industry, M is not econom-ically compelled to continue D’s distribution agree-ment. Under the distribution agreement, D has theexclusive right to sell shares of M and agrees to useits best efforts to solicit orders for the sale of shares ofM. D sells shares in M directly to the general public aswell as through brokers. When an investor places anorder for M shares with a broker, D pays the broker acommission for selling the shares to the investor. Un-der the distribution agreement, D receives compensa-tion from M in the form of 12b–1 fees (which equala percentage of M’s net asset value attributable to in-vestors that have held their shares for up to 6 years)and contingent deferred sales charges (which are paidif the investor redeems the purchased shares within 6years).

February 17, 2004 470 2004-7 I.R.B.

(ii) The distribution agreement is not an agree-ment providing D with the right to provide services,as described in paragraph (d)(6)(i)(B) of this section,because the distribution agreement can be termi-nated by M at will upon 60 days notice and M isnot economically compelled to continue the distri-bution agreement. Accordingly, D is not requiredto capitalize the costs of creating (or facilitating thecreation of) the distribution agreement under para-graphs (b)(1)(ii) or (v) of this section. In addition,as provided in paragraph (b)(3)(ii) of this section,amounts paid to create an agreement are treated asamounts that do not create a separate and distinctintangible asset. Accordingly, D also is not requiredto capitalize the costs of creating (or facilitating thecreation of) the distribution agreement under para-graph (b)(1)(iii) or (v) of this section.

(iii) Under paragraph (b)(3)(iii), the broker com-missions paid by D in performing services under thedistribution agreement do not create (or facilitate thecreation of) a separate and distinct intangible asset.In addition, the broker commissions do not create anintangible described in paragraph (d) of this section.Accordingly, D is not required to capitalize the bro-ker commissions under this section.

(m) Amortization. For rules relatingto amortization of certain intangibles, see§1.167(a)–3.

(n) Intangible interests in land. [Re-served].

(o) Effective date. This section appliesto amounts paid or incurred on or afterDecember 31, 2003.

(p) Accounting method changes — (1)In general. A taxpayer seeking to changea method of accounting to comply withthis section must secure the consent ofthe Commissioner in accordance with therequirements of §1.446–1(e). For the tax-payer’s first taxable year ending on orafter December 31, 2003, the taxpayer isgranted the consent of the Commissionerto change its method of accounting tocomply with this section, provided thetaxpayer follows the administrative proce-dures issued under §1.446–1(e)(3)(ii) forobtaining the Commissioner’s automaticconsent to a change in accounting method(for further guidance, for example, seeRev. Proc. 2002–9, 2002–1 C.B. 327, and§601.601(d)(2)(ii)(b) of this chapter).

(2) Scope limitations. Any limitationson obtaining the automatic consent of theCommissioner do not apply to a taxpayerseeking to change to a method of account-ing to comply with this section for its firsttaxable year ending on or after December31, 2003.

(3) Section 481(a) adjustment. Withthe exception of a change to a poolingmethod authorized by this section, thesection 481(a) adjustment for a change in

method of accounting to comply with thissection for a taxpayer’s first taxable yearending on or after December 31, 2003, isdetermined by taking into account onlyamounts paid or incurred in taxable yearsending on or after January 24, 2002. Ataxpayer seeking to change to a poolingmethod authorized by this section on orafter the effective date of these regulationsmust change to the method using a cut-offmethod.

§1.263(a)–5 Amounts paid or incurredto facilitate an acquisition of a trade orbusiness, a change in the capital structureof a business entity, and certain othertransactions.

(a) General rule. A taxpayer must cap-italize an amount paid to facilitate (withinthe meaning of paragraph (b) of this sec-tion) each of the following transactions,without regard to whether the transactionis comprised of a single step or a series ofsteps carried out as part of a single plan andwithout regard to whether gain or loss isrecognized in the transaction:

(1) An acquisition of assets that consti-tute a trade or business (whether the tax-payer is the acquirer in the acquisition orthe target of the acquisition).

(2) An acquisition by the taxpayer of anownership interest in a business entity if,immediately after the acquisition, the tax-payer and the business entity are relatedwithin the meaning of section 267(b) or707(b) (see §1.263(a)–4 for rules requiringcapitalization of amounts paid by the tax-payer to acquire an ownership interest in abusiness entity, or to facilitate the acquisi-tion of an ownership interest in a businessentity, where the taxpayer and the businessentity are not related within the meaning ofsection 267(b) or 707(b) immediately afterthe acquisition).

(3) An acquisition of an ownership in-terest in the taxpayer (other than an acqui-sition by the taxpayer of an ownership in-terest in the taxpayer, whether by redemp-tion or otherwise).

(4) A restructuring, recapitalization, orreorganization of the capital structure of abusiness entity (including reorganizationsdescribed in section 368 and distributionsof stock by the taxpayer as described insection 355).

(5) A transfer described in section 351or section 721 (whether the taxpayer is thetransferor or transferee).

(6) A formation or organization of a dis-regarded entity.

(7) An acquisition of capital.(8) A stock issuance.(9) A borrowing. For purposes of this

section, a borrowing means any issuanceof debt, including an issuance of debt inan acquisition of capital or in a recapital-ization. A borrowing also includes debtissued in a debt for debt exchange under§1.1001–3.

(10) Writing an option.(b) Scope of facilitate — (1) In gen-

eral. Except as otherwise provided in thissection, an amount is paid to facilitate atransaction described in paragraph (a) ofthis section if the amount is paid in theprocess of investigating or otherwise pur-suing the transaction. Whether an amountis paid in the process of investigatingor otherwise pursuing the transaction isdetermined based on all of the facts andcircumstances. In determining whether anamount is paid to facilitate a transaction,the fact that the amount would (or wouldnot) have been paid but for the transactionis relevant, but is not determinative. Anamount paid to determine the value orprice of a transaction is an amount paid inthe process of investigating or otherwisepursuing the transaction. An amount paidto another party in exchange for tangibleor intangible property is not an amountpaid to facilitate the exchange. For exam-ple, the purchase price paid to the targetof an asset acquisition in exchange for itsassets is not an amount paid to facilitatethe acquisition. Similarly, the purchaseprice paid by an acquirer to the target’sshareholders in exchange for their stockin a stock acquisition is not an amountpaid to facilitate the acquisition of thestock. See §1.263(a)–1, §1.263(a)–2, and§ 1.263(a)–4 for rules requiring capitaliza-tion of the purchase price paid to acquireproperty.

(2) Ordering rules. An amount paid inthe process of investigating or otherwisepursuing both a transaction described inparagraph (a) of this section and an ac-quisition or creation of an intangible de-scribed in §1.263(a)–4 is subject to therules contained in this section, and notto the rules contained in §1.263(a)–4. Inaddition, an amount required to be cap-

2004-7 I.R.B. 471 February 17, 2004

italized by §1.263(a)–1, §1.263(a)–2, or§1.263(a)–4 does not facilitate a transac-tion described in paragraph (a) of this sec-tion.

(c) Special rules for certain costs — (1)Borrowing costs. An amount paid to facili-tate a borrowing does not facilitate anothertransaction (other than the borrowing) de-scribed in paragraph (a) of this section.

(2) Costs of asset sales. An amount paidby a taxpayer to facilitate a sale of its as-sets does not facilitate another transaction(other than the sale) described in paragraph(a) of this section. For example, wherea target corporation, in preparation for amerger with an acquiring corporation, sellsassets that are not desired by the acquiringcorporation, amounts paid to facilitate thesale of the unwanted assets are not requiredto be capitalized as amounts paid to facili-tate the merger.

(3) Mandatory stock distributions. Anamount paid in the process of investigat-ing or otherwise pursuing a distributionof stock by a taxpayer to its sharehold-ers does not facilitate a transaction de-scribed in paragraph (a) of this section ifthe divestiture of the stock (or of proper-ties transferred to an entity whose stock isdistributed) is required by law, regulatorymandate, or court order. A taxpayer is notrequired to capitalize (under this section or§1.263(a)–4) an amount paid to organize(or facilitate the organization of) an entityif the entity is organized solely to receiveproperties that the taxpayer is required todivest by law, regulatory mandate, or courtorder and if the taxpayer distributes thestock of the entity to its shareholders. Ataxpayer also is not required to capital-ize (under this section or §1.263(a)–4) anamount paid to transfer property to an en-tity if the taxpayer is required to divestitself of that property by law, regulatorymandate, or court order and if the stock ofthe recipient entity is distributed to the tax-payer’s shareholders.

(4) Bankruptcy reorganization costs.An amount paid to institute or adminis-ter a proceeding under Chapter 11 of theBankruptcy Code by a taxpayer that is thedebtor under the proceeding constitutes anamount paid to facilitate a reorganizationwithin the meaning of paragraph (a)(4) ofthis section, regardless of the purpose forwhich the proceeding is instituted. Forexample, an amount paid to prepare andfile a petition under Chapter 11, to ob-

tain an extension of the exclusivity periodunder Chapter 11, to formulate plans ofreorganization under Chapter 11, to an-alyze plans of reorganization formulatedby another party in interest, or to contestor obtain approval of a plan of reorga-nization under Chapter 11 facilitates areorganization within the meaning of thissection. However, amounts specificallypaid to formulate, analyze, contest or ob-tain approval of the portion of a plan ofreorganization under Chapter 11 that re-solves tort liabilities of the taxpayer donot facilitate a reorganization within themeaning of paragraph (a)(4) of this sectionif the amounts would have been treated asordinary and necessary business expensesunder section 162 had the bankruptcy pro-ceeding not been instituted. In addition,an amount paid by the taxpayer to defendagainst the commencement of an invol-untary bankruptcy proceeding against thetaxpayer does not facilitate a reorgani-zation within the meaning of paragraph(a)(4) of this section. An amount paid bythe debtor to operate its business during aChapter 11 bankruptcy proceeding is notan amount paid to institute or administerthe bankruptcy proceeding and does notfacilitate a reorganization. Such amountis treated in the same manner as it wouldhave been treated had the bankruptcy pro-ceeding not been instituted.

(5) Stock issuance costs of open-endregulated investment companies. Amountspaid by an open-end regulated investmentcompany (within the meaning of section851) to facilitate an issuance of its stockare treated as amounts that do not facili-tate a transaction described in paragraph(a) of this section unless the amounts arepaid during the initial stock offering pe-riod.

(6) Integration costs. An amount paidto integrate the business operations of thetaxpayer with the business operations ofanother does not facilitate a transaction de-scribed in paragraph (a) of this section, re-gardless of when the integration activitiesoccur.

(7) Registrar and transfer agent fees forthe maintenance of capital stock records.An amount paid by a taxpayer to a reg-istrar or transfer agent in connection withthe transfer of the taxpayer’s capital stockdoes not facilitate a transaction describedin paragraph (a) of this section unless theamount is paid with respect to a specific

transaction described in paragraph (a). Forexample, a taxpayer is not required to capi-talize periodic payments to a transfer agentfor maintaining records of the names andaddresses of shareholders who trade thetaxpayer’s shares on a national exchange.By comparison, a taxpayer is required tocapitalize an amount paid to the transferagent for distributing proxy statements re-questing shareholder approval of a transac-tion described in paragraph (a) of this sec-tion.

(8) Termination payments and amountspaid to facilitate mutually exclusive trans-actions. An amount paid to terminate (orfacilitate the termination of) an agreementto enter into a transaction described inparagraph (a) of this section constitutes anamount paid to facilitate a second transac-tion described in paragraph (a) of this sec-tion only if the transactions are mutuallyexclusive. An amount paid to facilitate atransaction described in paragraph (a) ofthis section is treated as an amount paidto facilitate a second transaction describedin paragraph (a) of this section only if thetransactions are mutually exclusive.

(d) Simplifying conventions — (1) Ingeneral. For purposes of this section, em-ployee compensation (within the meaningof paragraph (d)(2) of this section), over-head, and de minimis costs (within themeaning of paragraph (d)(3) of this sec-tion) are treated as amounts that do notfacilitate a transaction described in para-graph (a) of this section.

(2) Employee compensation — (i) Ingeneral. The term employee compen-sation means compensation (includingsalary, bonuses and commissions) paid toan employee of the taxpayer. For purposesof this section, whether an individual isan employee is determined in accordancewith the rules contained in section 3401(c)and the regulations thereunder.

(ii) Certain amounts treated as em-ployee compensation. For purposes ofthis section, a guaranteed payment to apartner in a partnership is treated as em-ployee compensation. For purposes ofthis section, annual compensation paid toa director of a corporation is treated asemployee compensation. For example, anamount paid to a director of a corporationfor attendance at a regular meeting of theboard of directors (or committee thereof)is treated as employee compensation forpurposes of this section. However, an

February 17, 2004 472 2004-7 I.R.B.

amount paid to the director for attendanceat a special meeting of the board of direc-tors (or committee thereof) is not treatedas employee compensation. An amountpaid to a person that is not an employeeof the taxpayer (including the employer ofthe individual who performs the services)is treated as employee compensation forpurposes of this section only if the amountis paid for secretarial, clerical, or similaradministrative support services (other thanservices involving the preparation and dis-tribution of proxy solicitations and otherdocuments seeking shareholder approvalof a transaction described in paragraph (a)of this section). In the case of an affiliatedgroup of corporations filing a consolidatedfederal income tax return, a payment byone member of the group to a second mem-ber of the group for services performedby an employee of the second memberis treated as employee compensation ifthe services provided by the employeeare provided at a time during which bothmembers are affiliated.

(3) De minimis costs — (i) In general.The term de minimis costs means amounts(other than employee compensation andoverhead) paid in the process of investigat-ing or otherwise pursuing a transaction de-scribed in paragraph (a) of this section if, inthe aggregate, the amounts do not exceed$5,000 (or such greater amount as may beset forth in published guidance). If theamounts exceed $5,000 (or such greateramount as may be set forth in publishedguidance), none of the amounts are de min-imis costs within the meaning of this para-graph (d)(3). For purposes of this para-graph (d)(3), an amount paid in the form ofproperty is valued at its fair market valueat the time of the payment.

(ii) Treatment of commissions. Theterm de minimis costs does not includecommissions paid to facilitate a trans-action described in paragraph (a) of thissection.

(4) Election to capitalize. A taxpayermay elect to treat employee compensa-tion, overhead, or de minimis costs paid inthe process of investigating or otherwisepursuing a transaction described in para-graph (a) of this section as amounts thatfacilitate the transaction. The election ismade separately for each transaction andapplies to employee compensation, over-head, or de minimis costs, or to any com-bination thereof. For example, a taxpayer

may elect to treat overhead and de min-imis costs, but not employee compensa-tion, as amounts that facilitate the trans-action. A taxpayer makes the election bytreating the amounts to which the elec-tion applies as amounts that facilitate thetransaction in the taxpayer’s timely filedoriginal federal income tax return (includ-ing extensions) for the taxable year duringwhich the amounts are paid. In the caseof an affiliated group of corporations filinga consolidated return, the election is madeseparately with respect to each member ofthe group, and not with respect to the groupas a whole. In the case of an S corporationor partnership, the election is made by theS corporation or by the partnership, and notby the shareholders or partners. An elec-tion made under this paragraph (d)(4) is re-vocable with respect to each taxable yearfor which made only with the consent ofthe Commissioner.

(e) Certain acquisitive transactions —(1) In general. Except as provided in para-graph (e)(2) of this section (relating to in-herently facilitative amounts), an amountpaid by the taxpayer in the process of in-vestigating or otherwise pursuing a cov-ered transaction (as described in paragraph(e)(3) of this section) facilitates the trans-action within the meaning of this sectiononly if the amount relates to activities per-formed on or after the earlier of —

(i) The date on which a letter of intent,exclusivity agreement, or similar writtencommunication (other than a confidential-ity agreement) is executed by representa-tives of the acquirer and the target; or

(ii) The date on which the materialterms of the transaction (as tentativelyagreed to by representatives of the acquirerand the target) are authorized or approvedby the taxpayer’s board of directors (orcommittee of the board of directors) or, inthe case of a taxpayer that is not a corpora-tion, the date on which the material termsof the transaction (as tentatively agreedto by representatives of the acquirer andthe target) are authorized or approved bythe appropriate governing officials of thetaxpayer. In the case of a transaction thatdoes not require authorization or approvalof the taxpayer’s board of directors (orappropriate governing officials in the caseof a taxpayer that is not a corporation)the date determined under this paragraph(e)(1)(ii) is the date on which the acquirerand the target execute a binding written

contract reflecting the terms of the trans-action.

(2) Exception for inherently facilitativeamounts. An amount paid in the process ofinvestigating or otherwise pursuing a cov-ered transaction facilitates that transactionif the amount is inherently facilitative, re-gardless of whether the amount is paid foractivities performed prior to the date deter-mined under paragraph (e)(1) of this sec-tion. An amount is inherently facilitativeif the amount is paid for —

(i) Securing an appraisal, formal writtenevaluation, or fairness opinion related tothe transaction;

(ii) Structuring the transaction, includ-ing negotiating the structure of the transac-tion and obtaining tax advice on the struc-ture of the transaction (for example, ob-taining tax advice on the application ofsection 368);

(iii) Preparing and reviewing the doc-uments that effectuate the transaction (forexample, a merger agreement or purchaseagreement);

(iv) Obtaining regulatory approval ofthe transaction, including preparing and re-viewing regulatory filings;

(v) Obtaining shareholder approval ofthe transaction (for example, proxy costs,solicitation costs, and costs to promote thetransaction to shareholders); or

(vi) Conveying property between theparties to the transaction (for example,transfer taxes and title registration costs).

(3) Covered transactions. For purposesof this paragraph (e), the term coveredtransaction means the following transac-tions:

(i) A taxable acquisition by the taxpayerof assets that constitute a trade or business.

(ii) A taxable acquisition of an owner-ship interest in a business entity (whetherthe taxpayer is the acquirer in the acqui-sition or the target of the acquisition) if,immediately after the acquisition, the ac-quirer and the target are related within themeaning of section 267(b) or 707(b).

(iii) A reorganization described in sec-tion 368(a)(1)(A), (B), or (C) or a reorga-nization described in section 368(a)(1)(D)in which stock or securities of the corpo-ration to which the assets are transferredare distributed in a transaction which qual-ifies under section 354 or 356 (whether thetaxpayer is the acquirer or the target in thereorganization).

2004-7 I.R.B. 473 February 17, 2004

(f) Documentation of success-basedfees — An amount paid that is contingenton the successful closing of a transactiondescribed in paragraph (a) of this section isan amount paid to facilitate the transactionexcept to the extent the taxpayer maintainssufficient documentation to establish thata portion of the fee is allocable to activi-ties that do not facilitate the transaction.This documentation must be completed onor before the due date of the taxpayer’stimely filed original federal income taxreturn (including extensions) for the tax-able year during which the transactioncloses. For purposes of this paragraph (f),documentation must consist of more thanmerely an allocation between activitiesthat facilitate the transaction and activitiesthat do not facilitate the transaction, andmust consist of supporting records (forexample, time records, itemized invoices,or other records) that identify —

(1) The various activities performed bythe service provider;

(2) The amount of the fee (or percentageof time) that is allocable to each of thevarious activities performed;

(3) Where the date the activity wasperformed is relevant to understandingwhether the activity facilitated the transac-tion, the amount of the fee (or percentageof time) that is allocable to the perfor-mance of that activity before and after therelevant date; and

(4) The name, business address, andbusiness telephone number of the serviceprovider.

(g) Treatment of capitalized costs —(1) Tax-free acquisitive transactions. [Re-served].

(2) Taxable acquisitive transactions —(i) Acquirer. In the case of an acquisi-tion, merger, or consolidation that is notdescribed in section 368, an amount re-quired to be capitalized under this sectionby the acquirer is added to the basis of theacquired assets (in the case of a transac-tion that is treated as an acquisition of theassets of the target for federal income taxpurposes) or the acquired stock (in the caseof a transaction that is treated as an acqui-sition of the stock of the target for federalincome tax purposes).

(ii) Target — (A) Asset acquisition. Inthe case of an acquisition, merger, or con-solidation that is not described in section368 and that is treated as an acquisitionof the assets of the target for federal in-

come tax purposes, an amount required tobe capitalized under this section by the tar-get is treated as a reduction of the target’samount realized on the disposition of itsassets.

(B) Stock acquisition. [Reserved].(3) Stock issuance transactions. [Re-

served].(4) Borrowings. For the treatment of

amounts required to be capitalized underthis section with respect to a borrowing,see §1.446–5.

(5) Treatment of capitalized amounts byoption writer. An amount required to becapitalized by an option writer under para-graph (a)(10) of this section is not cur-rently deductible under section 162 or 212.Instead, the amount required to be capital-ized generally reduces the total premiumreceived by the option writer. However,other provisions of law may limit the re-duction of the premium by the capital-ized amount (for example, if the capital-ized amount is never deductible by the op-tion writer).

(h) Application to accrual method tax-payers. For purposes of this section,the terms amount paid and paymentmean, in the case of a taxpayer usingan accrual method of accounting, a li-ability incurred (within the meaning of§1.446–1(c)(1)(ii)). A liability may notbe taken into account under this sectionprior to the taxable year during which theliability is incurred.

(i) [Reserved].(j) Coordination with other provisions

of the Internal Revenue Code. Nothing inthis section changes the treatment of anamount that is specifically provided for un-der any other provision of the Internal Rev-enue Code (other than section 162(a) or212) or regulations thereunder.

(k) Treatment of indirect payments. Forpurposes of this section, references to anamount paid to or by a party include anamount paid on behalf of that party.

(l) Examples. The following examplesillustrate the rules of this section:

Example 1. Costs to facilitate. Q corporationpays its outside counsel $20,000 to assist Q in reg-istering its stock with the Securities and ExchangeCommission. Q is not a regulated investment com-pany within the meaning of section 851. Q’s pay-ments to its outside counsel are amounts paid to facil-itate the issuance of stock. Accordingly, Q must cap-italize its $20,000 payment under paragraph (a)(8) ofthis section (whether incurred before or after the is-

suance of the stock and whether or not the registrationis productive of equity capital).

Example 2. Costs to facilitate. Q corporationseeks to acquire all of the outstanding stock of Ycorporation. To finance the acquisition, Q must is-sue new debt. Q pays an investment banker $25,000to market the debt to the public and pays its outsidecounsel $10,000 to prepare the offering documentsfor the debt. Q’s payment of $35,000 facilitates aborrowing and must be capitalized under paragraph(a)(9) of this section. As provided in paragraph (c)(1)of this section, Q’s payment does not facilitate theacquisition of Y, notwithstanding the fact that Q in-curred the new debt to finance its acquisition of Y.See §1.446–5 for the treatment of Q’s capitalized pay-ment.

Example 3. Costs to facilitate. (i) Z agrees topay investment banker B $1,000,000 for B’s servicesin evaluating four alternative transactions ($250,000for each alternative): an initial public offering; a bor-rowing of funds; an acquisition by Z of a competitor;and an acquisition of Z by a competitor. Z eventuallydecides to pursue a borrowing and abandons the otheroptions.

(ii) The $250,000 payment to evaluate the possi-bility of a borrowing is an amount paid in the processof investigating or otherwise pursuing a transactiondescribed in paragraph (a)(9) of this section. Accord-ingly Z must capitalize that $250,000 payment to B.See §1.446–5 for the treatment of Z’s capitalized pay-ment.

(iii) The $250,000 payment to evaluate the pos-sibility of an initial public offering is an amount paidin the process of investigating or otherwise pursuing atransaction described in paragraph (a)(8) of this sec-tion. Accordingly, Z must capitalize that $250,000payment to B under this section. Because the bor-rowing and the initial public offering are not mutuallyexclusive transactions, the $250,000 is not treated asan amount paid to facilitate the borrowing. When Zabandons the initial public offering, Z may recoverunder section 165 the $250,000 paid to facilitate theinitial public offering.

(iv) The $500,000 paid by Z to evaluate the pos-sibilities of an acquisition of Z by a competitor andan acquisition of a competitor by Z are amounts paidin the process of investigating or otherwise pursuingtransactions described in paragraphs (a) and (e)(3) ofthis section. Accordingly, Z is only required to cap-italize under this section the portion of the $500,000payment that relates to inherently facilitative activi-ties under paragraph (e)(2) of this section or to ac-tivities performed on or after the date determined un-der paragraph (e)(1) of this section. Because the bor-rowing and the possible acquisitions are not mutuallyexclusive transactions, no portion of the $500,000 istreated as an amount paid to facilitate the borrowing.When Z abandons the acquisition transactions, Z mayrecover under section 165 any portion of the $500,000that was paid to facilitate the acquisitions.

Example 4. Corporate acquisition. (i) On Febru-ary 1, 2005, R corporation decides to investigate theacquisition of three potential targets: T corporation,U corporation, and V corporation. R’s considerationof T, U, and V represents the consideration of threedistinct transactions, any or all of which R might con-summate and has the financial ability to consummate.On March 1, 2005, R enters into an exclusivity agree-ment with T and stops pursuing U and V. On July 1,

February 17, 2004 474 2004-7 I.R.B.

2005, R acquires all of the stock of T in a transactiondescribed in section 368. R pays $1,000,000 to an in-vestment banker and $50,000 to its outside counselto conduct due diligence on T, U, and V; determinethe value of T, U, and V; negotiate and structure thetransaction with T; draft the merger agreement; se-cure shareholder approval; prepare SEC filings; andobtain the necessary regulatory approvals.

(ii) Under paragraph (e)(1) of this section, theamounts paid to conduct due diligence on T, U andV prior to March 1, 2005 (the date of the exclusiv-ity agreement), are not amounts paid to facilitate theacquisition of the stock of T, U or V and are not re-quired to be capitalized under this section. However,the amounts paid to conduct due diligence on T onand after March 1, 2005, are amounts paid to facili-tate the acquisition of the stock of T and must be cap-italized under paragraph (a)(2) of this section.

(iii) Under paragraph (e)(2) of this section, theamounts paid to determine the value of T, negotiateand structure the transaction with T, draft the mergeragreement, secure shareholder approval, prepare SECfilings, and obtain necessary regulatory approvals areinherently facilitative amounts paid to facilitate theacquisition of the stock of T and must be capitalized,regardless of whether those activities occur prior to,on, or after March 1, 2005.

(iv) Under paragraph (e)(2) of this section, theamounts paid to determine the value of U and V areinherently facilitative amounts paid to facilitate theacquisition of U or V and must be capitalized. Be-cause the acquisition of U, V, and T are not mutuallyexclusive transactions, the costs that facilitate the ac-quisition of U and V do not facilitate the acquisitionof T. Accordingly, the amounts paid to determine thevalue of U and V may be recovered under section 165in the taxable year that R abandons the planned merg-ers with U and V.

Example 5. Corporate acquisition; employeebonus. Assume the same facts as in Example 4,except R pays a bonus of $10,000 to one of its cor-porate officers who negotiated the acquisition of T.As provided by paragraph (d)(1) of this section, Yis not required to capitalize any portion of the bonuspaid to the corporate officer.

Example 6. Corporate acquisition; integrationcosts. Assume the same facts as in Example 4, exceptthat, before and after the acquisition is consummated,R incurs costs to relocate personnel and equipment,provide severance benefits to terminated employees,integrate records and information systems, preparenew financial statements for the combined entity, andreduce redundancies in the combined business oper-ations. Under paragraph (c)(6) of this section, thesecosts do not facilitate the acquisition of T. Accord-ingly, R is not required to capitalize any of these costsunder this section.

Example 7. Corporate acquisition; compensa-tion to target’s employees. Assume the same factsas in Example 4, except that, prior to the acquisition,certain employees of T held unexercised options is-sued pursuant to T’s stock option plan. These op-tions granted the employees the right to purchase Tstock at a fixed option price. The options did not havea readily ascertainable value (within the meaning of§1.83–7(b)), and thus no amount was included in theemployees’ income when the options were granted.As a condition of the acquisition, T is required to ter-minate its stock option plan. T therefore agrees to pay

its employees who hold unexercised stock options thedifference between the option price and the currentvalue of T’s stock in consideration of their agreementto cancel their unexercised options. Under paragraph(d)(1) of this section, T is not required to capitalizethe amounts paid to its employees. See section 83 forthe treatment of amounts received in cancellation ofstock options.

Example 8. Asset acquisition; employee compen-sation. N corporation owns tangible and intangibleassets that constitute a trade or business. M corpora-tion purchases all the assets of N in a taxable transac-tion. Under paragraph (a)(1) of this section, M mustcapitalize amounts paid to facilitate the acquisition ofthe assets of N. Under paragraph (d)(1) of this sec-tion, no portion of the salaries of M’s employees whowork on the acquisition are treated as facilitating thetransaction.

Example 9. Corporate acquisition; retainer. Ycorporation’s outside counsel charges Y $60,000 forservices rendered in facilitating the friendly acquisi-tion of the stock of Y corporation by X corporation.Y has an agreement with its outside counsel underwhich Y pays an annual retainer of $50,000. Y’soutside counsel has the right to offset amounts billedfor any legal services rendered against the annual re-tainer. Pursuant to this agreement, Y’s outside coun-sel offsets $50,000 of the legal fees from the acquisi-tion against the retainer and bills Y for the balance of$10,000. The $60,000 legal fee is an amount paid tofacilitate the acquisition of an ownership interest inY as described in paragraph (a)(3) of this section. Ymust capitalize the full amount of the $60,000 legalfee.

Example 10. Corporate acquisition; antitrust de-fense costs. On March 1, 2005, V corporation entersinto an agreement with X corporation to acquire allof the outstanding stock of X. On April 1, 2005, fed-eral and state regulators file suit against V to preventthe acquisition of X on the ground that the acquisi-tion violates antitrust laws. V enters into a consentagreement with regulators on May 1, 2005, that al-lows the acquisition to proceed, but requires V to holdseparate the business operations of X pending the out-come of the antitrust suit and subjects V to possibledivestiture. V acquires title to all of the outstandingstock of X on June 1, 2005. After June 1, 2005, theregulators pursue antitrust litigation against V seek-ing rescission of the acquisition. V pays $50,000 toits outside counsel for services rendered after June 1,2005, to defend against the antitrust litigation. V ulti-mately prevails in the antitrust litigation. V’s costs todefend the antitrust litigation are costs to facilitate itsacquisition of the stock of X under paragraph (a)(2)of this section and must be capitalized. Although ti-tle to the shares of X passed to V prior to the dateV incurred costs to defend the antitrust litigation, theamounts paid by V are paid in the process of pursuingthe acquisition of the stock of X because the acquisi-tion was not complete until the antitrust litigation wasultimately resolved. V must capitalize the $50,000 inlegal fees.

Example 11. Corporate acquisition; defensivemeasures. (i) On January 15, 2005, Y corporation,a publicly traded corporation, becomes the target ofa hostile takeover attempt by Z corporation. In aneffort to defend against the takeover, Y pays legalfees to seek an injunction against the takeover andinvestment banking fees to locate a potential “white

knight” acquirer. Y also pays amounts to complete adefensive recapitalization, and pays $50,000 to an in-vestment banker for a fairness opinion regarding Z’sinitial offer. Y’s efforts to enjoin the takeover andlocate a white knight acquirer are unsuccessful, andon March 15, 2005, Y’s board of directors decides toabandon its defense against the takeover and nego-tiate with Z in an effort to obtain the highest possi-ble price for its shareholders. After Y abandons itsdefense against the takeover, Y pays an investmentbanker $1,000,000 for a second fairness opinion andfor services rendered in negotiating with Z.

(ii) The legal fees paid by Y to seek an injunc-tion against the takeover are not amounts paid in theprocess of investigating or otherwise pursuing thetransaction with Z. Accordingly, these legal fees arenot required to be capitalized under this section.

(iii) The investment banking fees paid to searchfor a white knight acquirer do not facilitate an acqui-sition of Y by a white knight because none of Y’scosts with respect to a white knight were inherentlyfacilitative amounts and because Y did not reach thedate described in paragraph (e)(1) of this section withrespect to a white knight. Accordingly, these amountsare not required to be capitalized under this section.

(iv) The amounts paid by Y to investigate andcomplete the recapitalization must be capitalized un-der paragraph (a)(4) of this section.

(v) The $50,000 paid to the investment bankersfor a fairness opinion during Y’s defense against thetakeover and the $1,000,000 paid to the investmentbankers after Y abandons its defense against thetakeover are inherently facilitative amounts withrespect to the transaction with Z and must be capital-ized under paragraph (a)(3) of this section.

Example 12. Corporate acquisition; acquisitionby white knight. (i) Assume the same facts as in Ex-ample 11, except that Y’s investment bankers iden-tify three potential white knight acquirers: U corpo-ration, V corporation, and W corporation. Y pays itsinvestment bankers to conduct due diligence on thethree potential white knight acquirers. On March 15,2005, Y’s board of directors approves a tentative ac-quisition agreement under which W agrees to acquireall of the stock of Y, and the investment bankers stopdue diligence on U and V. On June 15, 2005, W ac-quires all of the stock of Y.

(ii) Under paragraph (e)(1) of this section, theamounts paid to conduct due diligence on U, V, andW prior to March 15, 2005 (the date of board of di-rectors’ approval) are not amounts paid to facilitatethe acquisition of the stock of Y and are not requiredto be capitalized under this section. However, theamounts paid to conduct due diligence on W on andafter March 15, 2005, facilitate the acquisition of thestock of Y and are required to be capitalized.

Example 13. Corporate acquisition; mutually ex-clusive costs. (i) Assume the same facts as in Exam-ple 11, except that Y’s investment banker finds W, awhite knight. Y and W execute a letter of intent onMarch 10, 2005. Under the terms of the letter of in-tent, Y must pay W a $10,000,000 break-up fee if themerger with W does not occur. On April 1, 2005, Zsignificantly increases the amount of its offer, and Ydecides to accept Z’s offer instead of merging with W.Y pays its investment banker $500,000 for inherentlyfacilitative costs with respect to the potential mergerwith W. Y also pays its investment banker $2,000,000for due diligence costs with respect to the potential

2004-7 I.R.B. 475 February 17, 2004

merger with W, $1,000,000 of which relates to ser-vices performed on or after March 10, 2005.

(ii) Y’s $500,000 payment for inherently facilita-tive costs and Y’s $1,000,000 payment for due dili-gence activities performed on or after March 10, 2005(the date the letter of intent with W is entered into),facilitate the potential merger with W. Because Ycould not merge with both W and Z, under paragraph(c)(8) of this section the $500,000 and $1,000,000payments also facilitate the transaction between Yand Z. Accordingly, Y must capitalize the $500,000and $1,000,000 payments as amounts that facilitatethe transaction with Z.

(iii) Similarly, because Y could not merge withboth W and Z, under paragraph (c)(8) of this sectionthe $10,000,000 termination payment facilitates thetransaction between Y and Z. Accordingly, Y mustcapitalize the $10,000,000 termination payment as anamount that facilitates the transaction with Z.

Example 14. Break-up fee; transactions notmutually exclusive. N corporation and U corporationenter into an agreement under which U would acquireall the stock or all the assets of N in exchange for Ustock. Under the terms of the agreement, if eitherparty terminates the agreement, the terminating partymust pay the other party $10,000,000. U decides toterminate the agreement and pays N $10,000,000.Shortly thereafter, U acquires all the stock of Vcorporation, a competitor of N. U had the finan-cial resources to have acquired both N and V. U’s$10,000,000 payment does not facilitate U’s acquisi-tion of V. Accordingly, U is not required to capitalizethe $10,000,000 payment under this section.

Example 15. Corporate reorganization; initialpublic offering. Y corporation is a closely held cor-poration. Y’s board of directors authorizes an initialpublic offering of Y’s stock to fund future growth. Ypays $5,000,000 in professional fees for investmentbanking services related to the determination of theoffering price and legal services related to the devel-opment of the offering prospectus and the registra-tion and issuance of stock. The investment bankingand legal services are performed both before and afterboard authorization. Under paragraph (a)(8) of thissection, the $5,000,000 is an amount paid to facilitatea stock issuance.

Example 16. Auction. (i) N corporation seeks todispose of all of the stock of its wholly owned sub-sidiary, P corporation, through an auction process andrequests that each bidder submit a non-binding pur-chase offer in the form of a draft agreement. Q cor-poration hires an investment banker to assist in thepreparation of Q’s bid to acquire P and to conduct adue diligence investigation of P. On July 1, 2005, Qsubmits its draft agreement. On August 1, 2005, Ninforms Q that it has accepted Q’s offer, and presentsQ with a signed letter of intent to sell all of the stockof P to Q. On August 5, 2005, Q’s board of directorsapproves the terms of the transaction and authorizesQ to execute the letter of intent. Q executes a bindingletter of intent with N on August 6, 2005.

(ii) Under paragraph (e)(1) of this section, theamounts paid by Q to its investment banker that arenot inherently facilitative and that are paid for ac-tivities performed prior to August 5, 2005 (the dateQ’s board of directors approves the transaction), arenot amounts paid to facilitate the acquisition of P.Amounts paid by Q to its investment banker for ac-tivities performed on or after August 5, 2005, and

amounts paid by Q to its investment banker that areinherently facilitative amounts within the meaning ofparagraph (e)(2) of this section are required to be cap-italized under this section.

Example 17. Stock distribution. Z corporationdistributes natural gas throughout state Y. The fed-eral government brings an antitrust action against Zseeking divestiture of certain of Z’s natural gas dis-tribution assets. As a result of a court ordered divesti-ture, Z and the federal government agree to a plan ofdivestiture that requires Z to organize a subsidiary toreceive the divested assets and to distribute the stockof the subsidiary to its shareholders. During 2005, Zpays $300,000 to various independent contractors forthe following services: studying customer demand inthe area to be served by the divested assets, identify-ing assets to be transferred to the subsidiary, organiz-ing the subsidiary, structuring the transfer of assetsto the subsidiary to qualify as a tax-free transactionto Z, and distributing the stock of the subsidiary tothe stockholders. Under paragraph (c)(3) of this sec-tion, Z is not required to capitalize any portion of the$300,000 payments.

Example 18. Bankruptcy reorganization. (i) Xcorporation is the defendant in numerous lawsuits al-leging tort liability based on X’s role in manufactur-ing certain defective products. X files a petition forreorganization under Chapter 11 of the BankruptcyCode in an effort to manage all of the lawsuits in asingle proceeding. X pays its outside counsel to pre-pare the petition and plan of reorganization, to an-alyze adequate protection under the plan, to attendhearings before the Bankruptcy Court concerning theplan, and to defend against motions by creditors andtort claimants to strike the taxpayer’s plan.

(ii) X’s reorganization under Chapter 11 of theBankruptcy Code is a reorganization within the mean-ing of paragraph (a)(4) of this section. Under para-graph (c)(4) of this section, amounts paid by X to itsoutside counsel to prepare, analyze or obtain approvalof the portion of X’s plan of reorganization that re-solves X’s tort liability do not facilitate the reorga-nization and are not required to be capitalized, pro-vided that such amounts would have been treated asordinary and necessary business expenses under sec-tion 162 had the bankruptcy proceeding not been in-stituted. All other amounts paid by X to its outsidecounsel for the services described above (includingall amounts paid to prepare the bankruptcy petition)facilitate the reorganization and must be capitalized.

(m) Effective date. This section appliesto amounts paid or incurred on or afterDecember 31, 2003.

(n) Accounting method changes — (1)In general. A taxpayer seeking to changea method of accounting to comply withthis section must secure the consent ofthe Commissioner in accordance with therequirements of §1.446–1(e). For the tax-payer’s first taxable year ending on orafter December 31, 2003, the taxpayer isgranted the consent of the Commissionerto change its method of accounting tocomply with this section, provided thetaxpayer follows the administrative proce-dures issued under §1.446–1(e)(3)(ii) for

obtaining the Commissioner’s automaticconsent to a change in accounting method(for further guidance, for example, seeRev. Proc. 2002–9, 2002–1 C.B. 327, and§601.601(d)(2)(ii)(b) of this chapter).

(2) Scope limitations. Any limitationson obtaining the automatic consent of theCommissioner do not apply to a taxpayerseeking to change to a method of account-ing to comply with this section for its firsttaxable year ending on or after December31, 2003.

(3) Section 481(a) adjustment. Thesection 481(a) adjustment for a change inmethod of accounting to comply with thissection for a taxpayer’s first taxable yearending on or after December 31, 2003, isdetermined by taking into account onlyamounts paid or incurred in taxable yearsending on or after January 24, 2002.

Par. 5. Section 1.446–5 is added to readas follows:

§1.446–5 Debt issuance costs.

(a) In general. This section providesrules for allocating debt issuance costsover the term of the debt. For purposes ofthis section, the term debt issuance costsmeans those transaction costs incurredby an issuer of debt (that is, a borrower)that are required to be capitalized under§1.263(a)–5. If these costs are otherwisedeductible, they are deductible by theissuer over the term of the debt as deter-mined under paragraph (b) of this section.

(b) Method of allocating debt issuancecosts — (1) In general. Solely for purposesof determining the amount of debt issuancecosts that may be deducted in any period,these costs are treated as if they adjustedthe yield on the debt. To effect this, the is-suer treats the costs as if they decreased theissue price of the debt. See §1.1273–2 todetermine issue price. Thus, debt issuancecosts increase or create original issue dis-count and decrease or eliminate bond is-suance premium.

(2) Original issue discount. Any re-sulting original issue discount is taken intoaccount by the issuer under the rules in§1.163–7, which generally require the useof a constant yield method (as described in§1.1272–1) to compute how much origi-nal issue discount is deductible for a pe-riod. However, see §1.163–7(b) for spe-cial rules that apply if the total original is-sue discount on the debt is de minimis.

February 17, 2004 476 2004-7 I.R.B.

(3) Bond issuance premium. Any re-maining bond issuance premium is takeninto account by the issuer under the rulesof §1.163–13, which generally require theuse of a constant yield method for purposesof allocating bond issuance premium to ac-crual periods.

(c) Examples. The following examplesillustrate the rules of this section:

Example 1. (i) On January 1, 2004, X borrows$10,000,000. The principal amount of the loan($10,000,000) is repayable on December 31, 2008,and payments of interest in the amount of $500,000are due on December 31 of each year the loan is out-standing. X incurs debt issuance costs of $130,000to facilitate the borrowing.

(ii) Under §1.1273–2, the issue price of the loanis $10,000,000. However, under paragraph (b) ofthis section, X reduces the issue price of the loan bythe debt issuance costs of $130,000, resulting in anissue price of $9,870,000. As a result, X treats theloan as having original issue discount in the amountof $130,000 (stated redemption price at maturity of$10,000,000 minus the issue price of $9,870,000).Because this amount of original issue discount ismore than the de minimis amount of original issuediscount for the loan determined under §1.1273–1(d)($125,000 ($10,000,000 x .0025 x 5)), X must allo-cate the original issue discount to each year based onthe constant yield method described in §1.1272–1(b).See §1.163–7(a). Based on this method and a yieldof 5.30%, compounded annually, the original is-sue discount is allocable to each year as follows:$23,385 for 2004, $24,625 for 2005, $25,931 for2006, $27,306 for 2007, and $28,753 for 2008.

Example 2. (i) Assume the same facts as in Ex-ample 1, except that X incurs debt issuance costs of$120,000 rather than $130,000.

(ii) Under §1.1273–2, the issue price of the loanis $10,000,000. However, under paragraph (b) ofthis section, X reduces the issue price of the loan bythe debt issuance costs of $120,000, resulting in an

issue price of $9,880,000. As a result, X treats theloan as having original issue discount in the amountof $120,000 (stated redemption price at maturity of$10,000,000 minus the issue price of $9,880,000).Because this amount of original issue discount isless than the de minimis amount of original issuediscount for the loan determined under §1.1273–1(d)($125,000), X does not have to use the constant yieldmethod described in §1.1272–1(b) to allocate theoriginal issue discount to each year. Instead, under§1.163–7(b)(2), X can choose to allocate the originalissue discount to each year on a straight-line basisover the term of the loan or in proportion to thestated interest payments ($24,000 each year). X alsocould choose to deduct the original issue discount atmaturity of the loan. X makes its choice by reportingthe original issue discount in a manner consistentwith the method chosen on X’s timely filed federalincome tax return for 2004. If X wanted to use theconstant yield method, based on a yield of 5.279%,compounded annually, the original issue discount isallocable to each year as follows: $21,596 for 2004,$22,736 for 2005, $23,937 for 2006, $25,200 for2007, and $26,531 for 2008.

(d) Effective date. This section appliesto debt issuance costs paid or incurred fordebt instruments issued on or after Decem-ber 31, 2003.

(e) Accounting method changes — (1)Consent to change. An issuer required tochange its method of accounting for debtissuance costs to comply with this sectionmust secure the consent of the Commis-sioner in accordance with the requirementsof §1.446–1(e). Paragraph (e)(2) of thissection provides the Commissioner’s auto-matic consent for certain changes.

(2) Automatic consent. The Com-missioner grants consent for an issuer tochange its method of accounting for debt

issuance costs incurred for debt instru-ments issued on or after December 31,2003. Because this change is made ona cut-off basis, no items of income ordeduction are omitted or duplicated and,therefore, no adjustment under section 481is allowed. The consent granted by thisparagraph (e)(2) applies provided—

(i) The change is made to comply withthis section;

(ii) The change is made for the first tax-able year for which the issuer must accountfor debt issuance costs under this section;and

(iii) The issuer attaches to its federal in-come tax return for the taxable year con-taining the change a statement that it haschanged its method of accounting underthis section.

PART 602—OMB CONTROLNUMBERS UNDER THE PAPERWORKREDUCTION ACT

Par. 6. The authority citation for part602 continues to read as follows:

Authority: 26 U.S.C. 7805.Par. 7. In §602.101, paragraph (b) is

amended by adding an entry in numericalorder for §1.263(a)–5 to read as follows:

§602.101 OMB Control numbers.

* * * * *(b) * * *

CFR part or section whereidentified and described

Current OMBcontrol No.

* * * * *

1.263(a)–5. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1545–1870

* * * * *

Mark E. Matthews,Deputy Commissioner forServices and Enforcement.

Approved December 19, 2003.

Pamela F. Olson,Assistant Secretary of the Treasury.

(Filed by the Office of the Federal Register on December 31,2003, 8:45 a.m., and published in the issue of the FederalRegister for January 5, 2004, 69 F.R. 435)

Section 401.—QualifiedPension, Profit-Sharing,and Stock Bonus Plans26 CFR 1.401(a)(4)–1: Nondiscrimination require-ments of section 401(a)(4).

Whether the application of section 410(b)(6)(C) ofthe Code to a defined benefit plan causes that de-fined benefit plan to fail the nondiscrimination re-quirements of section 1.401(a)(4)–1(b)(2) of the In-

2004-7 I.R.B. 477 February 17, 2004

come Tax Regulations. See Rev. Rul. 2004-11, page480.

26 CFR 1.401(a)(31)–1: Requirement to offer directrollover of eligible rollover distributions.

If the requirements of this revenue procedure aresatisfied, the Service will accept the position that acorporation’s S election is not affected when an ESOPdistributes stock of that corporation to a participant’sIRA in a direct rollover. See Rev. Proc. 2004-14,page 489.

(Also, §§ 402, 403, 408, 457.)

Plan qualification; rollovers. Thisruling describes a situation where an eligi-ble retirement plan separately accounts foramounts attributable to rollover contribu-tions to the plan. As a result, distributionsof those amounts are not subject to the re-strictions on permissible timing that ap-ply, under the applicable requirements ofthe Code, to distributions of other amountsfrom the plan.

Rev. Rul. 2004–12

ISSUE

If an eligible retirement plan sepa-rately accounts for amounts attributableto rollover contributions to the plan, aredistributions of those amounts subject tothe restrictions on permissible timing thatapply, under the applicable requirementsof the Internal Revenue Code, to distribu-tions of other amounts from the plan?

LAW AND ANALYSIS

Portability

Prior to the enactment of the EconomicGrowth and Tax Relief Reconciliation Actof 2001 (“EGTRRA”), Pub. L. 107–16,certain restrictions applied to rollovers byindividuals of funds accumulated in retire-ment plans maintained by their employersor in IRAs maintained by the individuals.Sections 641 through 643 of EGTRRA(as amended by § 411 of the Job Creationand Worker Assistance Act of 2002, Pub.L. 107–147) substantially increased therollover opportunities available to individ-uals, by expanding both the types of planseligible to accept rollovers and the typesof funds that can be rolled over. Rulesapplicable to rollovers (including the new

portability rules) are contained in the fol-lowing sections of the Code:

(1) Section 402(c) provides that if anyamount paid from a qualified trust in aneligible rollover distribution is transferredto an eligible retirement plan in a rolloverthat meets the requirements of that section,the amount transferred is not includible ingross income for the taxable year in whichpaid. Similar rules apply to § 403(a) an-nuity plans, § 403(b) tax-sheltered annu-ities, IRAs and § 457 eligible governmen-tal plans.

(2) Section 402(c)(2) provides that theportion of an eligible rollover distributionthat would otherwise not be includible ingross income cannot be rolled over un-less such previously taxed amounts aretransferred either (i) in a direct trustee-to-trustee transfer to a defined contributionplan qualified under § 401(a) that agreesto separately account for such amounts or(ii) to an IRA.

(3) Section 401(a)(31) requires thata qualified trust provide for the di-rect trustee-to-trustee transfer (a “directrollover”) of eligible rollover distribu-tions. In the case of previously taxedamounts, the limitations described in thepreceding paragraph apply. Similar rulesapply to § 403(a) annuity plans, § 403(b)tax-sheltered annuities and § 457 eligiblegovernmental plans. (See §§ 403(a)(5),403(b)(10) and 457(d)(1)(C).)

(4) Section 408(d)(3)(A) provides thatpreviously taxed amounts distributed froman IRA may only be rolled over to anotherIRA.

(5) Section 402(c)(10) provides thata § 457 eligible governmental plan maynot accept a rollover from another typeof eligible retirement plan unless it sepa-rately accounts for such rollover. Section72(t)(9) provides that a distribution fromsuch separate account is subject to the10-percent additional tax under § 72(t) asif the distribution were from a plan de-scribed in § 401(a).

(6) Section 402(f) requires that the re-cipient of an eligible rollover distributionbe apprised of the fact that, if the distri-bution is rolled over to an eligible retire-ment plan, distributions from such eligibleretirement plan may be subject to restric-tions and tax consequences that are differ-ent from those applicable to distributionsfrom the plan making the eligible rolloverdistribution. (See § 402(f)(1)(E).)

Distribution Rules Applicable to Rollovers

In many instances, the Code, or IncomeTax Regulations or other guidance issuedby the Service, provides explicitly for thetreatment of rollover contributions. Forexample, the survivor annuity require-ments of §§ 401(a)(11) and 417 apply toall “benefits provided under a plan, in-cluding benefits attributable to rollovercontributions” (§ 1.401(a)–20, Q&A–11).Similarly, pursuant to § 411(a)(11)(D),in determining whether an employee’saccrued benefit exceeds $5,000 (and thusmay not be immediately distributed with-out the consent of the employee), a planmay provide that rollover contributions(and attributable earnings) are disregarded.

In other instances, rollovers are implic-itly included. For example, § 72(t) im-poses a 10-percent additional tax on a tax-payer who receives “any amount” from aqualified retirement plan (within the mean-ing of § 4974(c)) except as otherwise pro-vided in § 72(t); the reference to “anyamount” and the lack of an exception foramounts attributable to rollover contribu-tions indicate that § 72(t) is applied with-out regard to whether the amounts dis-tributed are attributable to rollover contri-butions.

The rules restricting the timing of dis-tributions, other than those relating torequired minimum distributions under§ 401(a)(9), generally apply to employercontributions made to the plan or annu-ity. For example, §§ 401(k)(2)(B) and403(b)(11) prohibit the distribution of em-ployer contributions that are elective de-ferrals (within the meaning of § 402(g)(3))prior to the occurrence of certain events.Section 403(b)(7)(A)(ii) provides thatemployer contributions to custodial ac-counts treated as § 403(b) tax-shelteredannuities may not be distributed prior tothe occurrence of certain events. Section457(d)(1)(A) provides generally that aneligible plan meets the distribution re-quirements of § 457(d) if under the planamounts will not be made available to par-ticipants or beneficiaries earlier than thecalendar year in which the participant at-tains age 701/2 or when the participant hasa severance from employment. Similarly,regulations under § 401 provide generalrules regarding the timing of distributionsof employer contributions to pension,profit-sharing and stock bonus plans (see

February 17, 2004 478 2004-7 I.R.B.

§ 1.401–1(b)(1)(i), (ii) and (iii)). Thus,§ 1.401–1(b)(1)(i) provides that a pensionplan is a plan established and maintainedby an employer primarily to provide sys-tematically for the payment of definitelydeterminable benefits to employees overa period of years, usually for life, afterretirement. The Service has interpretedthis to mean that employer contributionsto a pension plan may not be distributedprior to retirement, death, disability orother severance from employment, or ter-mination of the plan.

Rev. Rul. 69–277, 1969–1 C.B. 116,and Rev. Rul. 94–76, 1994–2 C.B. 46, ad-dress distributions of other types of con-tributions. Rev. Rul. 69–277 providesthat a pension plan may permit distribu-tion to an employee of amounts attribut-able to the employee’s after-tax contribu-tions prior to the employee’s terminationof employment. Rev. Rul. 94–76 providesthat a profit-sharing plan may permit theimmediate distribution of amounts attrib-utable to a rollover.

Based on the foregoing, eligible re-tirement plans that separately account foramounts attributable to rollover contri-butions may permit the distribution ofamounts attributable to an individual’srollover, at any time, pursuant to the indi-vidual’s request (with spousal consent, ifapplicable to the plan).

In contrast to rollovers, Rev. Rul.94–76 and Rev. Rul. 2002–42, 2002–2C.B. 76, provide that, in the case ofa § 414(l) transfer between dissimilar§ 401(a) plans (or a plan amendmenttreated as such a transfer), the character-istics of the transferor plan continue toapply to the transferred assets held in thetransferee plan. Thus, when employees’accounts in an employer’s money pur-chase pension plan are transferred to theemployer’s profit-sharing plan, the trans-ferred assets remain subject to the rulesapplicable to distributions from a moneypurchase pension plan: for example, theymay not be distributed prior to retirement,death, disability or other severance fromemployment, or termination of the plan,even though other assets in the plan maybe distributed earlier. Similarly, pursuantto § 401(a)(11)(B), a defined contributionplan not otherwise subject to the survivorannuity requirements of §§ 401(a)(11)and 417 is subject to such requirements ifthe plan is a transferee of a plan subject

to such requirements. However, if thetransferee plan separately accounts for thetransferred assets and any income thereon,the survivor annuity requirements onlyapply with respect to the transferred assets(and income thereon).

In the case of § 403(b) tax-sheltered an-nuities, Rev. Rul. 90–24, 1990–1 C.B.97, provides that an amount directly trans-ferred from an annuity subject to the earlydistribution restrictions of § 403(b)(7) or(11) to an annuity not otherwise subject tosuch restrictions is not treated as a distri-bution if the transferred amount continuesto be subject to the early distribution re-strictions of § 403(b)(7) or (11), respec-tively. In the case of plan-to-plan trans-fers between § 457 eligible governmentalplans, § 1.457–10(b)(6) provides that anamount transferred is subject to the dis-tribution restrictions of the receiving planin the same manner as if the transferredamount had originally been deferred underthe receiving plan if the participant is per-forming services for the entity maintainingthe receiving plan.

HOLDING

If an eligible retirement plan sepa-rately accounts for amounts attributable torollover contributions to the plan, distri-butions of those amounts are not subjectto the restrictions on permissible timingthat apply, under the applicable require-ments of the Internal Revenue Code, todistributions of other amounts from theplan. Accordingly, the plan may permitthe distribution of amounts attributable torollover contributions at any time pursuantto an individual’s request.

Thus, for example, if the receiving planis a money purchase pension plan and theplan separately accounts for amounts at-tributable to rollover contributions, a planprovision permitting the in-service distri-bution of those amounts will not cause theplan to fail to satisfy the requirements of§ 1.401–1(b)(1)(i). Similarly, if the receiv-ing plan is a § 457 eligible governmentalplan or a tax-sheltered annuity describedin § 403(b)(7) or (11), amounts attributableto rollovers that are maintained in separateaccounts are permitted to be distributedat any time even though distribution ofother amounts under the plan or contract isrestricted pursuant to § 457(d)(1)(A) and§ 403(b)(7) or (11), respectively.

However, a distribution of amounts at-tributable to a rollover contribution is sub-ject to the survivor annuity requirements of§§ 401(a)(11) and 417, the minimum dis-tribution requirements of § 401(a)(9), andthe additional income tax on prematuredistributions under § 72(t), as applicable tothe receiving plan. Thus, for example, if adistribution from an IRA is rolled over intoa plan described in § 401(a), any distribu-tion from the § 401(a) plan of amounts at-tributable to the rollover would be subjectto the exceptions from the § 72(t) tax thatapply to § 401(a) plans and not the excep-tions that apply to IRAs.

This holding does not apply to amountsreceived by a plan as a result of a merger,consolidation or transfer of plan assets un-der § 414(l), nor to plan-to-plan transfersotherwise permitted between § 403(b) tax-sheltered annuities and between § 457 eli-gible governmental plans.

DRAFTING INFORMATION

The principal author of this revenue rul-ing is Roger Kuehnle of the EmployeePlans, Tax Exempt and Government Enti-ties Division. For further information re-garding this revenue ruling, please con-tact Employee Plans’ taxpayer assistancetelephone service at 1–877–829–5500 (atoll-free number), between the hours of8:00 a.m. and 6:30 p.m. Eastern Time,Monday through Friday. Mr. Kuehnlemay be reached at 202–283–9888 (not atoll-free number).

Section 402.—Taxability ofBeneficiary of Employees’Trust

Whether amounts are eligible for rollover distribu-tions. See Rev. Rul. 2004-12, page 478.

If the requirements of this revenue procedure aresatisfied, the Service will accept the position that acorporation’s S election is not affected when an ESOPdistributes stock of that corporation to a participant’sIRA in a direct rollover. See Rev. Proc. 2004-14,page 489.

Section 403.—Taxation ofEmployee Annuities

Whether amounts attributable to rollovers that areaccounted for separately are subject to the plan’s gen-

2004-7 I.R.B. 479 February 17, 2004

eral distribution requirements. See Rev. Rul. 2004-12, page 478.

Section 408.—IndividualRetirement Accounts

Whether amounts attributable to rollovers that areaccounted for separately are subject to the IRA’s gen-eral distribution requirements. See Rev. Rul. 2004-12, page 478.

Section 409.—Qualifi-cations for Tax CreditEmployee Stock Own-ership Plans

If the requirements of this revenue procedure aresatisfied, the Service will accept the position that acorporation’s S election is not affected when an ESOPdistributes stock of that corporation to a participant’sIRA in a direct rollover. See Rev. Proc. 2004-14,page 489.

Section 410.—MinimumParticipation Standards26 CFR 1.410(b)–2: Minimum coverage require-ments (after 1993).(Also, § 401; § 1.401(a)(4)–1.)

Coverage; special rules; request forcomments. This ruling describes the ap-plication of the special coverage rule foracquisitions and dispositions in section410(b)(6)(C) of the Code in a situationinvolving a defined benefit plan and aprofit-sharing plan that includes a quali-fied cash or deferred arrangement undersection 401(k)(2). In addition, the rulingholds that a significant change in a plan orin the coverage of a plan during the transi-tion period under section 410(b)(6)(C)(ii)curtails the period effective as of the dateof the change and does not make the planretroactively ineligible to apply section410(b)(6)(C). Finally, the ruling also asksfor comments as to other situations thatmay arise under section 410(b)(6)(C).

Rev. Rul. 2004–11

ISSUES

(1) Will the plans described below betreated as satisfying the requirements of§ 1.401(a)(4)–1(b)(2) of the Income TaxRegulations, relating to nondiscriminatorycontributions or benefits, and the require-ments of §§ 401(k) and 401(m) of the Inter-nal Revenue Code, as well as the require-

ments of § 410(b), by reason of the specialrule in § 410(b)(6)(C) for certain acquisi-tions or dispositions?

(2) Does a significant change in a plan’scoverage during the transition period un-der § 410(b)(6)(C)(ii) make a plan ineligi-ble for the special rule in § 410(b)(6)(C),or merely curtail the transition period dur-ing which the special rule may be appliedto the plan?

FACTS

Subsidiary S, which is part of X, acontrolled group of corporations under§ 414(b), sponsors a defined benefit pen-sion plan and a profit-sharing plan forits employees. Both plans are qualifiedunder § 401(a), and the plan year of eachplan is the calendar year. Only employ-ees of S are eligible to participate in theplans. The defined benefit plan wouldsatisfy a nondiscrimination safe harborunder § 1.401(a)(4)–3(b) but for the factthat the plan provides a subsidized earlyretirement benefit that is not currentlyavailable to substantially all employees.For purposes of satisfying the nondis-crimination requirements of § 401(a)(4),the defined benefit plan is therefore re-structured into two component plans, aspermitted by § 1.401(a)(4)–9(c), one com-ponent consisting of all the accruals andother benefits, rights, and features pro-vided to those employees to whom thesubsidized early retirement benefit is cur-rently available, and the other componentconsisting of all the accruals and otherbenefits, rights, and features provided tothose employees to whom the subsidizedearly retirement benefit is not currentlyavailable. Each of the component plansseparately satisfies a nondiscriminationsafe harbor under § 1.401(a)(4)–3(b) andthe other nondiscrimination requirementsof § 401(a)(4) and also separately satisfies§ 410(b) by satisfying the ratio percentagetest of § 1.410(b)–2(b)(2). The profit-shar-ing plan includes only a qualified cashor deferred arrangement, as defined in§ 401(k)(2), and matching contributionsthat are subject to the nondiscriminationrequirements of § 401(m).

On June 22, 2004, all of the stockof S is sold to corporation Y. Immedi-ately before the sale, the defined benefitplan maintained by S satisfies the mini-mum coverage requirements of § 410(b)

by satisfying the ratio percentage test of§ 1.410(b)–2(b)(2), and the qualified cashor deferred arrangement and the matchingcontribution portion of the profit-sharingplan each satisfy the ratio percentage test.For this purpose, neither plan is aggre-gated with any other plan, and X doesnot apply the coverage requirements of§ 410(b) on the basis of separate lines ofbusiness under § 414(r). In addition, eachof the component plans under the definedbenefit plan satisfies the nondiscrimina-tion requirements of § 401(a)(4) and theratio percentage test of § 1.410(b)–2(b)(2)immediately before the sale.

S continues to maintain the profit-shar-ing plan without change after the sale. Salso continues to maintain the defined ben-efit plan, but amends the plan to signifi-cantly change the benefit formula effectiveApril 1, 2005.

LAW

Under § 401(a)(3), a plan is not qual-ified under section § 401(a) unless itsatisfies the minimum coverage require-ments of § 410(b) and § 1.410(b)–2. Inorder to satisfy § 410(b) and § 1.410(b)–2,the group of employees benefiting undera plan must not discriminate in favor ofhighly compensated employees (withinthe meaning of § 414(q)). In general, aplan satisfies § 410(b) for a plan year if theplan satisfies either the ratio percentagetest in § 1.410(b)–2(b)(2) or the averagebenefit test in § 1.410(b)–2(b)(3) for theplan year. A plan satisfies the ratio per-centage test for a plan year if, for the planyear, the plan benefits a percentage ofnonhighly compensated employees whichis at least 70 percent of the percentageof highly compensated employees ben-efiting under the plan. A plan satisfiesthe average benefit test for a plan yearif, for the plan year, the plan satisfiesthe nondiscriminatory classification testin § 410(b)(2)(A)(i) and § 1.410(b)–4and the average benefit percentage test in§ 410(b)(2)(A)(ii) and § 1.410(b)–5. Ingeneral, the average benefit percentagetest requires the determination of eachemployee’s employee benefit percentage,based on employer-provided contributionsor benefits, under all of the employer’squalified plans.

Section 410(b)(6)(C) provides a specialrule for applying the minimum coverage

February 17, 2004 480 2004-7 I.R.B.

requirements in situations involving cer-tain acquisitions or dispositions. Under§ 410(b)(6)(C), if a person becomes, orceases to be, a member of a group de-scribed in § 414(b), (c), (m), or (o), therequirements of § 410(b) are treated ashaving been met during the transition pe-riod with respect to any plan covering em-ployees of such person or any other mem-ber of such group, provided two condi-tions are met. First, the plan must havesatisfied the requirements of § 410(b) im-mediately before each such change in themembers of a group. Second, the cover-age under the plan must not significantlychange during the transition period (otherthan by reason of the change in the mem-bers of a group) or the plan must meet suchother requirements as the Secretary mayprescribe. The transition period is definedin § 410(b)(6)(C)(ii) as the period begin-ning on the date of the change in membersof a group and ending on the last day ofthe first plan year beginning after the dateof such change.

For purposes of § 410(b)(6)(C), § 1.410(b)–2(f) provides that the terms “acqui-sition” and “disposition” refer to an as-set or stock acquisition, merger, or othersimilar transaction involving a change inemployer of the employees of a trade orbusiness. Section 1.410(b)–2(f) providesthat a plan may be treated as satisfying§ 410(b) during the transition period fol-lowing an acquisition or disposition if theplan satisfies § 410(b) (without regard to§ 410(b)(6)(C)) immediately before the ac-quisition or disposition and there is no sig-nificant change in the plan or in the cover-age of the plan other than the acquisitionor disposition.

Section 1.410(b)–7 provides the def-inition of plan that applies for purposesof § 410(b). In general, each single planwithin the meaning of § 414(l) is a separateplan for purposes of § 410(b), but certainplans must be treated as comprising twoor more separate plans, each of which isa single plan for purposes of § 410(b).Under § 1.410(b)–7(c), the portion of aplan that is a “section 401(k) plan” istreated as a separate plan for purposes of§ 410(b). (A “section 401(k) plan” is aplan consisting solely of elective contribu-tions described in §1.401(k)–1(g)(3) undera qualified cash or deferred arrangementdescribed in § 1.401(k)–1(a)(4)(i).) Simi-larly, the portion of a plan that is a “section

401(m) plan” is treated as a separate planfor purposes of § 410(b). (A “section401(m) plan” is a plan consisting solelyof employee contributions described in§1.401(m)–1(f)(6) or matching contribu-tions described in §1.401(m)–1(f)(12), orboth.) Thus, in the case of a plan thatincludes elective contributions and em-ployee or matching contributions, the planmust be disaggregated. The portion of theplan that is a section 401(k) plan and theportion of the plan that is a section 401(m)plan must separately satisfy § 410(b).

In general, for purposes of the ratiopercentage test and the nondiscriminatoryclassification test, an employer may per-missively aggregate two or more plans,other than plans that are required to bedisaggregated. If the employer does so,the aggregated plans are treated as a sin-gle plan for purposes of §§ 410(b) and401(a)(4).

Under § 401(a)(4), a plan is not qual-ified under § 401(a) unless the contribu-tions or benefits under the plan do notdiscriminate in favor of highly compen-sated employees (within the meaningof § 414(q)). Sections 1.401(a)(4)–1through 1.401(a)(4)–13 set forth the ex-clusive rules for determining whether aplan satisfies this requirement. Section1.401(a)(4)–1(b)(2) requires that eitherthe contributions or the benefits underthe plan be nondiscriminatory in amount.Section 1.401(a)(4)–3 contains the rulesfor determining whether employer-de-rived benefits under a defined benefitplan are nondiscriminatory in amount.Unless the plan satisfies a nondiscrimina-tion safe harbor under § 1.401(a)(4)–3(b),the plan must satisfy the general test fornondiscrimination in amount of bene-fits under § 1.401(a)(4)–3(c) for the planyear. However, § 1.401(a)(4)–1(c)(4)(iii)and § 1.401(a)(4)–9(c) allow a plan to betreated as consisting of two or more com-ponent plans for purposes of satisfying§ 401(a)(4). If each component plan satis-fies §§ 401(a)(4) and 410(b) as if it werea separate plan, then the plan is treated assatisfying § 401(a)(4). A component planconsists of all the allocations or accrualsand other benefits, rights, and features pro-vided under the plan to a selected groupof employees. Every employee must beincluded in one and only one componentplan under a plan for a plan year. Therequirement that each component plan

satisfy § 410(b) is in addition to the re-quirement that the plan satisfy § 410(b).Section 1.401(a)(4)–1(c)(4)(iv) providesthat, except as otherwise specifically pro-vided, references to satisfying § 410(b) inthe regulations under § 401(a)(4) mean sat-isfying § 1.410(b)–2, taking into accountany special rules available in satisfyingthat section (other than the permissiveaggregation rules of § 1.410(b)–7(d)).

Section 401(k)(1) provides that aprofit-sharing or stock bonus plan doesnot fail to be qualified under § 401(a)merely because the plan includes a qual-ified cash or deferred arrangement. Sec-tion 401(k)(3)(A)(i) provides that a cashor deferred arrangement is not a qual-ified cash or deferred arrangement un-less those employees eligible to benefitunder the arrangement satisfy the pro-visions of § 410(b)(1). (This require-ment corresponds to the requirement in§ 1.410(b)–7(c) that a section 401(k) planmust separately satisfy § 410(b).) Section401(k)(3)(A)(ii) provides that a cash ordeferred arrangement is not a qualifiedcash or deferred arrangement unless thearrangement satisfies the actual deferralpercentage (ADP) test described therein.

Section 401(m) provides specialnondiscrimination requirements for em-ployee and matching contributions undera qualified defined contribution plan. Sec-tion 401(m)(1) provides that the amountof employee and matching contributionsunder a defined contribution plan satisfiesthe requirements of § 401(a)(4) only ifthe employee and matching contributionsunder the plan satisfy the actual contribu-tion percentage (ACP) test described in§ 401(m)(2).

ANALYSIS

The sale of S to Y is an acquisi-tion or disposition within the mean-ing of § 1.410(b)–2(f), and the definedbenefit plan and each of the disag-gregated portions of the profit-sharingplan satisfy § 410(b) (without regard to§ 410(b)(6)(C)) immediately before theacquisition or disposition. The sale wouldaffect the data required to be taken intoaccount in applying the requirements of§ 410(b) to the plans in the absence of thespecial rule in § 410(b)(6)(C).

There is no significant change in thesection 401(k) plan or in the coverage of

2004-7 I.R.B. 481 February 17, 2004

the section 401(k) plan (other than the ac-quisition or disposition) during the transi-tion period under § 410(b)(6)(C)(ii). Like-wise, there is no significant change in thesection 401(m) plan or in the coverage ofthe section 401(m) plan. Therefore, thespecial rule in § 410(b)(6)(C) may be ap-plied to each of the disaggregated portionsof the profit-sharing plan for the transitionperiod starting on the date of sale of S toY (June 22, 2004) and continuing throughDecember 31, 2005 (that is, the last dayof the plan year beginning on January 1,2005). Accordingly, under § 410(b)(6)(C),the profit-sharing plan will be treated assatisfying the requirements of § 410(b)during the transition period.

The coverage requirement for a qual-ified cash or deferred arrangement in§ 401(k)(3)(A)(i) requires the group ofemployees eligible to benefit under thearrangement to satisfy § 410(b). There-fore, the special rule for certain acqui-sitions or dispositions in § 410(b)(6)(C)and § 1.410(b)–2(f) may be applied forpurposes of satisfying that requirement.Accordingly, the cash or deferred ar-rangement in the profit-sharing plan willbe treated as satisfying the coverage re-quirement in § 401(k)(3)(A)(i) during thetransition period.

On the other hand, the ADP test andACP test described in § 401(k)(3)(A)(ii)and § 401(m)(2), respectively, do not re-fer to § 410(b). Rather, these tests requirethe comparison of the average of the ac-tual deferral ratios and actual contributionratios of the group of eligible highly com-pensated employees and the group of el-igible nonhighly compensated employeesunder the plan. Therefore, the special rulefor certain acquisitions or dispositions in§ 410(b)(6)(C) and § 1.410(b)–2(f) doesnot apply for purposes of satisfying theADP test or the ACP test and thus pro-vides no relief from satisfying these testsusing the averages of the actual deferral ra-tios and actual contribution ratios, respec-tively, of the eligible employees under theplan. Accordingly, the cash or deferred ar-rangement and the matching contributionsunder the profit-sharing plan must satisfythe ADP test and the ACP test followingthe sale of S to Y using these ratios.

The benefit formula in the defined ben-efit plan does not satisfy a nondiscrimina-tion safe harbor because the plan providesa subsidized early retirement benefit that

is not currently available to substantiallyall employees. However, for purposes ofsatisfying § 401(a)(4), the plan is restruc-tured, as permitted by § 1.401(a)(4)–9(c),into two component plans each of whichseparately satisfies a nondiscriminationsafe harbor. Section 1.401(a)(4)–9(c) re-quires that each component plan separatelysatisfy § 410(b) as well as § 401(a)(4).Pursuant to § 1.401(a)(4)–1(c)(4)(iv), therequirements of § 410(b) are to be appliedto the component plans taking into accountany special rules available in satisfying§ 1.410(b)–2 (other than the permissive ag-gregation rules of § 1.410(b)–7(d)). Thus,for purposes of satisfying the requirementsof § 1.401(a)(4)–9(c), the special rule in§ 410(b)(6)(C) and § 1.410(b)–2(f) maybe applied, provided (1) each componentplan separately satisfies §§ 401(a)(4) and410(b) immediately before the acquisitionor disposition and (2) neither the plan northe coverage under the plan is significantlychanged during the transition period (otherthan by reason of the change in the mem-bers of a group) or the plan meets suchother requirements as the Secretary mayprescribe.

Each component plan under the de-fined benefit plan separately satisfies§§ 401(a)(4) and 410(b) immediately be-fore the sale of S to Y, and there is nosignificant change in the defined benefitplan or in the coverage under the definedbenefit plan (other than the acquisition ordisposition) during the period followingthe sale and prior to April 1, 2005.

The plan amendment significantlychanging the benefit formula in the de-fined benefit plan, effective April 1, 2005,is a significant change in the plan or inthe coverage of the plan (other than theacquisition or disposition) for purposes of§ 410(b)(6)(C) and § 1.410(b)–2(f). Forthis purpose, a change in the plan meansa change in the benefits or in the benefitlevels under the plan.

The effect of § 410(b)(6)(C) is to pro-vide time for a plan sponsor to considerwhat coverage or other plan changes willneed to be made for the sponsor’s plansto continue to satisfy the minimum cov-erage requirements following an acquisi-tion or disposition. Thus, the plan spon-sor is relieved from having to immediatelyamend its plans or otherwise effect cover-age changes to comply with § 410(b). Therule in § 410(b)(6)(C) is permissive, so that

plan sponsors may choose to satisfy the re-quirements of § 410(b) after an acquisitionor disposition either with or without regardto § 410(b)(6)(C). Furthermore, the transi-tion period described in § 410(b)(6)(C)(ii)is the maximum period allowed to a plansponsor before the sponsor must take intoaccount the change in the employer re-sulting from the acquisition or disposition.There is no requirement to apply the reliefin § 410(b)(6)(C) for the whole of the al-lowable transition period. Thus, the effectof a significant change in a plan or in thecoverage of a plan (other than the acqui-sition or disposition) during the transitionperiod under § 410(b)(6)(C)(ii) is to curtailthe period effective as of the date of thechange and not to make the plan retroac-tively ineligible to apply § 410(b)(6)(C).Accordingly, under § 410(b)(6)(C), the de-fined benefit plan will be treated as satis-fying the requirements of § 410(b) and therequirements of § 1.401(a)(4)–1(b)(2) dur-ing the applicable transition period fromJune 22, 2004, through March 31, 2005.

Starting April 1, 2005, the definedbenefit plan must satisfy the require-ments of § 410(b) and the requirementsof § 1.401(a)(4)–1(b)(2) without regardto the special rule in § 410(b)(6)(C). Thatis, the plan must satisfy these require-ments taking into account the employeesof Y. The profit-sharing plan must sat-isfy the requirements of §§ 410(b) and401(k)(3)(A)(i) taking into account theemployees of Y starting the first day ofthe plan year beginning on January 1,2006. The plan amendment significantlychanging the benefit formula in the de-fined benefit plan does not curtail theprofit-sharing plan’s transition period un-der § 410(b)(6)(C)(ii) because the planssatisfy the requirements of § 410(b) inde-pendently of each other.

HOLDINGS

ISSUE (1)

Under the facts set forth, the definedbenefit plan will be treated as satisfy-ing the requirements of § 410(b) and therequirements of § 1.401(a)(4)–1(b)(2) dur-ing the applicable transition period fromJune 22, 2004, through March 31, 2005.The profit-sharing plan will be treated assatisfying the minimum coverage require-ments of § 410(b) by reason of the special

February 17, 2004 482 2004-7 I.R.B.

rule in § 410(b)(6)(C) during the plan’sapplicable transition period from the dateof the sale through December 31, 2005.The cash or deferred arrangement willalso be treated as satisfying the coveragerequirement of § 401(k)(3)(A)(i) duringthis transition period. However, the cashor deferred arrangement and the match-ing contributions under the profit-sharingplan will not, by reason of the specialrule in § 410(b)(6)(C), be treated as sat-isfying the ADP test or the ACP test in§ 401(k)(3)(A)(ii) and § 401(m)(2), and,therefore, the plan must satisfy these testsfor the plan years ending on December 31,2004, and December 31, 2005.

ISSUE (2)

A significant change in a plan or in thecoverage of a plan curtails the transitionperiod under § 410(b)(6)(C)(ii), so that§ 410(b)(6)(C) ceases to apply to the planas of the date of the change. The changedoes not make the plan retroactively ineli-gible to apply § 410(b)(6)(C).

REQUEST FOR COMMENTS

The facts in this revenue ruling de-scribe only one of many situations thatmay involve the application of the specialrule for acquisitions and dispositions in§ 410(b)(6)(C). Different types of transac-tions or different fact patterns may raisequestions other than those addressed inthis revenue ruling or may require differ-ent analyses. The Service and the Treasuryare considering issuing additional guid-ance regarding § 410(b)(6)(C) of a morecomprehensive nature and invite publiccomments. Comments are invited on theissues on which guidance is needed and onthe appropriate resolution of these issues.

Commentators are specifically asked tocomment on what the appropriate analy-sis would be if the facts of the ruling werechanged as in the situations described be-low. In commenting on these situations,commentators are asked to address:

• the requirement in § 410(b)(6)(C)(i)(I)(i.e., that the plan satisfy § 410(b) im-mediately prior to the acquisition ordisposition), and

• the requirement in § 410(b)(6)(C)(i)(II)(i.e., that coverage under the plan not

be significantly changed duringthe transition period),

including how each of these two require-ments applies with respect to the seller,the transferred employees, and the buyerin each situation; and

• whether, without creating a potentialfor abuse, there are appropriate cir-cumstances where a plan that is re-quired to calculate employee alloca-tion or accrual rates or employee bene-fit percentages to determine that the re-quirements of § 401(a)(4) or § 410(b)(e.g., the general test or the averagebenefit percentage test) are satisfiedshould be treated as satisfying those re-quirements during the transition periodfollowing a § 410(b)(6)(C) acquisitionor disposition.

In the following situations, assume thatthe defined benefit plan sponsored by S(Plan A) provides a benefit of one percentof compensation per year of service andthat S does not sponsor a profit-sharingplan. Otherwise, the facts are the same asin the revenue ruling except as describedin each of the three situations.

Situation 1: Effect of Transaction ifPart of Seller’s Plan is Spun-off and isMaintained by Buyer. At the time of thesale of S to Y, Plan A covers other employ-ees of group X as well as employees of S.When S is sold to Y, Plan A is split into twoplans, Plan A–1 which covers employeesof group X who are not employees of S,and Plan A–2, which covers employees ofS. Plan A–2 is thus spun off as a separateplan that is maintained by S after the saleof S to Y.

a. Assume that, had the sale of S to Ynot occurred, Plan A–1 would notsatisfy § 410(b) without being aggre-gated with Plan A–2 (or that Plan A–2would not satisfy § 410(b) withoutbeing aggregated with Plan A–1).

b. Assume that, after the spin-off, a sig-nificant change is made to Plan A–2,but the change is not made to PlanA–1.

Commentators are also asked to con-sider what the analysis would be if, whenS is sold to Y, there is no plan spin-off. Asa result, the employees of S do not benefitunder a plan after the sale.

Situation 2: Effect on Buyer’s Plan ifSeller’s Plan is Assumed by Buyer. S isa division of group X, rather than a sub-sidiary, and the transaction is the sale ofall of the assets and liabilities of divisionS to Y. In conjunction with the sale, all di-vision S employees become employees ofY. Y also maintains a defined benefit plan(Plan B) that provides a benefit of two per-cent of compensation for each year of ser-vice. Plan A is assumed by Y, so that em-ployees of S continue to accrue benefitsat the rate of one percent of compensationper year of service. The other employeesof Y do not participate in Plan A, and theemployees of S do not participate in PlanB. For purposes of analyzing the applica-tion of § 410(b)(6)(C) to Plan B, considerboth the situation where the exclusion ofthe employees of S from Plan B is the re-sult of Plan B’s existing terms and the situ-ation where the exclusion is the result of anamendment to Plan B adopted at the timeof the sale of S to Y.

Situation 3: Effect on Buyer’s Plan ifSeller’s Plan is Not Assumed by Buyer.The transaction is the same as in Situation2, the sale of the assets and liabilities of di-vision S to Y and the transfer of division Semployees. However, Y does not assumePlan A, and there are three alternative sce-narios with respect to the coverage of em-ployees of S under Plan B:

a. Plan B does not exclude the employ-ees of S. As a result, the employees ofS immediately begin to accrue bene-fits at the rate of two percent of com-pensation per year of service underPlan B.

b. Plan B excludes the employees of S.As a result, the employees of S do notbenefit under a plan after the sale.

c. Plan B is amended at the time of thesale of S to Y to provide a benefitof one percent of compensation peryear of service to the employees of S,while continuing to provide the twopercent benefit formula for the otheremployees of Y.

The Service also welcomes commentson other situations or other questions re-lating to the application of § 410(b)(6)(C).

2004-7 I.R.B. 483 February 17, 2004

SUBMISSION OF COMMENTS

Comments should be submitted byMay 17, 2004, to CC:PA:LPD:RU (Rev.Rul. 2004–11), Room 5203, Internal Rev-enue Service, POB 7604 Ben FranklinStation, Washington, D.C. 20044. Com-ments may be hand delivered betweenthe hours of 8 a.m. and 5 p.m., Mondaythrough Friday to CC:PA:LPD:RU (Rev.Rul. 2004–11), Courier’s Desk, InternalRevenue Service, 1111 Constitution Ave.,NW, Washington D.C. Alternatively, com-ments may be submitted via the Internet atNotice.Comments@irscounsel.treas.gov.All comments will be available for publicinspection.

DRAFTING INFORMATION

The principal authors of this revenueruling are James Flannery of EmployeePlans, Tax Exempt and Government Enti-ties Division, and R. Lisa Mojiri-Azad ofthe Office of Division Counsel/AssociateChief Counsel (Tax Exempt and Govern-ment Entities). For further information re-garding this revenue ruling, please contactthe Employee Plans’ taxpayer assistancetelephone service at 1–877–829–5500 be-tween the hours of 8:00 a.m. and 6:30p.m. Eastern time, Monday through Fri-day (a toll-free number). Mr. Flannerymay be reached at 1–202–283–9888 (nota toll-free call). Ms. Mojiri-Azad maybe reached at 1–202–622–6060 (also not atoll-free call).

Section 411.—MinimumVesting Standards26 CFR 1.411(a)–11: Restriction and valuation ofdistributions.

Significant detriment; defined con-tribution plan; allocation of expenses.This ruling describes the application of thesignificant detriment rule in regulationssection 1.411(a)–11(c)(2)(i) in relation-ship to the Department of Labor’s FieldAssistance Bulletin 2003–3 pertaining tothe allocation of expenses in a definedcontribution plan.

Rev. Rul. 2004–10

ISSUE

Does a defined contribution plan un-der which the accounts of former employ-ees are charged a pro rata share of theplan’s reasonable administrative expenses,but the accounts of current employees arenot charged those expenses, fail to satisfythe requirements of § 411(a)(11) of the In-ternal Revenue Code?

FACTS

Employer X maintains Plan A, a quali-fied defined contribution plan. Plan A pro-vides that a participant who terminates em-ployment will receive payment of his orher vested account balance under the plancommencing at normal retirement age or,if later, at termination of employment (sub-ject to § 401(a)(9), in the case of a 5 per-cent owner). The plan permits a partici-pant who terminates employment prior tonormal retirement age to elect at any timeafter termination of employment to receivean immediate distribution of the vested ac-count balance.

Plan A provides that certain adminis-trative expenses, e.g., investment man-agement fees, are to be allocated to theindividual accounts of participants andbeneficiaries based upon the ratio of eachaccount balance to the total account bal-ances of all participants and beneficiaries.Plan A further provides that the share ofthese expenses allocable to each partici-pant’s and beneficiary’s account will bepaid from the plan and charged againstthe account to the extent not paid by theemployer. Employer X pays the portionof these expenses allocable to the accountsof current employees, but not those of for-mer employees or their beneficiaries. Allof the administrative expenses are properplan expenses, within the meaning of theEmployee Retirement Income SecurityAct of 1974 (ERISA), and are reasonablewith respect to the services to which theyrelate.

LAW AND ANALYSIS

Section 411(a)(11)(A) sets forth re-quirements that must be satisfied with re-spect to certain distributions in order for aplan to be qualified under § 401(a). Under

§ 411(a)(11), if the present value of a par-ticipant’s nonforfeitable benefit exceeds$5,000, a plan meets the requirementsof § 411(a)(11) only if the plan providesthat the benefit may not be immediatelydistributable without the consent of theparticipant.

Section 1.411(a)–11(c)(2)(i) of the In-come Tax Regulations provides that con-sent to a distribution is not valid if, underthe plan, a significant detriment is imposedon any participant who does not consentto the distribution. That regulation furtherprovides that whether or not a significantdetriment is imposed is determined by theCommissioner by examining the particularfacts and circumstances.

An allocation of administrative ex-penses of a defined contribution plan tothe individual account of a participant whodoes not consent to a distribution is not asignificant detriment within the meaningof § 1.411(a)–11(c)(2)(i) if that allocationis reasonable and otherwise satisfies therequirements of Title I of ERISA, such asa pro rata allocation. Such an allocationdoes not impose a detriment so signifi-cant as to be inconsistent with the deferralrights mandated by § 411(a)(11) becauseanalogous fees would be imposed in themarketplace, either implicitly or explicitly,for a comparable investment outside theplan (e.g., fees charged by an investmentmanager for an IRA investment). Accord-ingly, whether or not such expenses arecharged to the accounts of current employ-ees, charging such expenses on a pro ratabasis to the accounts of former employeesis not a significant detriment, within themeaning of § 1.411(a)–11(c)(2)(i), that isimposed on a participant who does notconsent to a distribution.

On May 19, 2003, the Employee Bene-fits Security Administration (the EBSA) ofthe Department of Labor issued Field As-sistance Bulletin (FAB) 2003–3 which setsforth guidelines on the allocation of ad-ministrative expenses among plan partic-ipants in a defined contribution plan. As-suming that the expenses at issue are bothproper expenses of the defined contribu-tion plan and reasonable expenses with re-spect to the services to which they relate,FAB 2003–3 states that, for purposes of Ti-tle I of ERISA, certain administrative ex-penses may be allocated on a pro rata basisand certain administrative expenses may

February 17, 2004 484 2004-7 I.R.B.

properly be charged to an individual partic-ipant rather than allocated among all planparticipants.

However, not every method of allo-cating plan expenses is reasonable and amethod that is not reasonable could resultin a significant detriment. For example,allocating the expenses of active employ-ees pro rata to all accounts, including theaccounts of both active and former em-ployees, while allocating the expenses offormer employees only to their accountswould not be reasonable since former em-ployees would be bearing more than anequitable portion of the plan’s expenses.Accordingly, such an allocation of ex-penses could be a significant detriment.

Taxpayers are also reminded that theallocation of plan expenses must com-ply with the nondiscrimination rules of§ 401(a)(4). The method of allocatingplan expenses is a plan right or featuredescribed under § 1.401(a)(4)–4(e)(3)(i).For example, if, in anticipation of the di-vorce of a plan participant who is a highlycompensated employee, the plan’s methodof allocating expenses is changed so thatthe expense of a determination of whetheran order constitutes a qualified domesticrelations order under § 414(p) ceases tobe allocated solely to the account of theparticipant for whom the expense is in-curred, but instead is allocated pro ratato all accounts, the timing of such changemay cause the plan to fail to satisfy therequirements of § 1.401(a)(4)–1(b)(3) and(4) with respect to the nondiscriminatoryavailability of benefits, rights and fea-tures and with respect to the timing of planamendments.

HOLDINGS

Plan A does not fail to satisfy the re-quirements of § 411(a)(11) merely becauseit charges reasonable plan administrativeexpenses to the accounts of former em-ployees and their beneficiaries on a prorata basis, but does not charge the accountsof current employees. Plan A also wouldnot fail to comply with the requirementsof § 411(a)(11) merely because it chargedreasonable plan administrative expenses tothe accounts of former employees and theirbeneficiaries, but not the accounts of cur-rent employees, on another reasonable ba-sis that complies with the requirements ofTitle I of ERISA.

DRAFTING INFORMATION

The principal author of this revenueruling is Michael Rubin of the EmployeePlans, Tax Exempt and Government En-tities Division. For further informationregarding this revenue ruling, please con-tact Employee Plans’ taxpayer assistancetelephone service at 1–877–829–5500(a toll-free number) between the hoursof 8:00 a.m. and 6:30 p.m. EasternTime, Monday through Friday (a toll-freecall). Mr. Rubin may be reached at (202)283–9888 (not a toll-free call).

Section 412.—MinimumFunding Standards

Procedures with respect to applications for waiversof the minimum funding standards under section412(d) of the Code and section 303 of ERISA are setforth. See Rev. Proc. 2004-15, page 490.

Section 416.—SpecialRules for Top-Heavy Plans

Top-heavy status; special rules. Thisruling describes four situations where anon-governmental profit-sharing plan con-tains a cash or deferred arrangement de-scribed in section 401(k) of the Code thatprovides for safe harbor matching contri-butions. In the first situation, the rul-ing holds that the requirements of section416(g)(4)(H) are met for that year. In theother situations, the ruling holds that thecontributions do not meet the requirementsof section 416(g)(4)(H).

Rev. Rul. 2004–13

ISSUE

In the situations described below,which plans meet the requirements of§ 416(g)(4)(H) of the Internal RevenueCode for the 2004 plan year so that theyare not subject to the top-heavy rules in§ 416?

FACTS

Situation 1. A nongovernmentalprofit-sharing plan containing a cash or de-ferred arrangement (“CODA”) describedin § 401(k) provides for safe harbor match-ing contributions that are intended to sat-isfy the requirements of § 401(k)(12)(B)and otherwise satisfies the requirements

of § 401(k)(12). The plan also permits theemployer to make a nonelective contribu-tion for any plan year at the employer’sdiscretion. The nonelective contributionis subject to 5-year vesting described in§ 411(a)(2)(A) and is allocated to par-ticipants’ accounts in the same ratio thateach participant’s compensation bears tothe compensation of all participants. Theplan is a calendar-year plan and coversall employees of the employer (includ-ing highly compensated employees asdefined in § 414(q)) who have 1 year ofservice and are age 21 or older. Other thanelective contributions and the matchingcontributions, no other contributions aremade to the plan for 2004 and there are noforfeitures.

Situation 2. The facts are the same asin Situation 1, except the employer makesa discretionary nonelective contribution tothe plan for 2004.

Situation 3. The facts are the same asin Situation 1, except forfeitures occur in2004 due to the severance from employ-ment of a participant who was not fullyvested in amounts attributable to discre-tionary nonelective contributions made ina prior year. Pursuant to the terms of theplan, forfeitures are allocated to partici-pants’ accounts for 2004 in the same man-ner as nonelective contributions.

Situation 4. The facts are the same as inSituation 1, except employees are permit-ted to make elective contributions immedi-ately upon commencement of employmentbut are not eligible for matching contribu-tions until they have completed 1 year ofservice with the employer.

LAW AND ANALYSIS

Under § 416, a plan that is a top-heavyplan (as defined in § 416(g)) for a planyear must satisfy the vesting requirementsof § 416(b) and the minimum benefit re-quirements of § 416(c) for such plan year.Section 416 does not apply to any govern-mental plan.

Section 416(g)(4)(H) provides thatthe term “top-heavy plan” does not in-clude a plan that consists solely of (1)a CODA that meets the requirements of§ 401(k)(12) and (2) matching contri-butions that meet the requirements of§ 401(m)(11). Section 416(g)(4)(H),which is effective for years beginning af-ter December 31, 2001, was added to the

2004-7 I.R.B. 485 February 17, 2004

Code by the Economic Growth and TaxRelief Reconciliation Act of 2001, Pub.L. 107–16.

The determination of whether a planis a top-heavy plan is made on a year-by-year basis. Thus, a plan that satis-fies § 416(g)(4)(H) for one plan year maybe subject to the top-heavy requirementsthe next plan year if it does not satisfy§ 416(g)(4)(H) for the next plan year.

Section 401(k)(12) and § 401(m)(11)provide design-based safe harbor methodsfor satisfying the actual deferral percent-age (“ADP”) nondiscrimination test con-tained in § 401(k)(3)(A)(ii) and the actualcontribution percentage (“ACP”) nondis-crimination test contained in § 401(m)(2).Section 401(k)(12) provides that a CODAis treated as satisfying the ADP test if theCODA meets certain contribution and no-tice requirements. To satisfy the ADP testsafe harbor contribution requirement, anemployer must make either (1) a nonelec-tive contribution equal to at least 3 percentof each eligible nonhighly compensatedemployee’s compensation (“safe harbornonelective contribution”) or (2) a match-ing contribution that satisfies certain min-imum amount and rate conditions (“safeharbor matching contribution”). Matchingcontributions do not satisfy § 401(k)(12)or § 401(m)(11) if the rate of matchingcontributions for a highly compensatedemployee at any rate of elective contribu-tions is greater than that for a nonhighlycompensated employee who is eligibleto make elective contributions. Also, aplan does not meet the requirements of§ 401(k)(12) if, under the terms of theplan, a nonhighly compensated employeeis eligible to make elective contributionsbut is not eligible to receive either a safeharbor nonelective contribution or a safeharbor matching contribution. Safe harbornonelective contributions and safe harbormatching contributions must be nonfor-feitable when contributed to the plan andsubject to withdrawal restrictions.

Section 401(m)(11) provides that a de-fined contribution plan is treated as sat-isfying the ACP test for matching contri-butions if the plan meets the requirementsof § 401(k)(12) and in addition meets cer-tain limitations on the amount and rate ofmatching contributions available under theplan.

In Situation 1, although the plan pro-vides for discretionary nonelective con-

tributions, none are made for 2004 andthus only contributions described in§ 401(k)(12) or § 401(m)(11) are madeto the plan for that year.

In Situation 2, the employer makes adiscretionary nonelective contribution for2004, a type of contribution that is not de-scribed in § 401(k)(12) or § 401(m)(11).

In Situation 3, the allocation of forfei-tures to participants’ accounts does not sat-isfy the requirements for safe harbor non-elective contributions under § 401(k)(12).

In Situation 4, under the plan, newlyhired nonhighly compensated employeeswho make elective contributions will notbe eligible to receive any matching con-tributions until they have completed 1year of service. Since this will result ina greater rate of matching contributionsfor highly compensated employees thanfor nonhighly compensated employees,the matching contributions do not sat-isfy the requirements of § 401(k)(12) (or§ 401(m)(11)). Further, since all eligiblenonhighly compensated employees un-der the plan do not receive safe harbornonelective contributions or safe harbormatching contributions, the matching con-tributions made under the plan do notsatisfy the requirements of § 401(k)(12).However, certain plans that provide forearly participation may satisfy the re-quirements of § 401(k)(12) with respectto the portion of the plan that coversemployees who have completed the min-imum age and service requirements of§ 410(a)(1), while satisfying the ADPtest of § 401(k)(3)(A)(ii) for the eligi-ble employees who have not completedthe minimum age and service require-ments. Unless a plan (within the meaningof § 414(l)) meets the requirements of§ 416(g)(4)(H), no portion of the planwill satisfy § 416(g)(4)(H). (See Notice2000–3, 2000–1 C.B. 413, Q&A–10.)

HOLDINGS

In Situation 1, the plan meets the re-quirements of § 416(g)(4)(H) and is there-fore not subject to the top-heavy rules in§ 416 for 2004 because no other contri-butions are made to the plans other thancontributions described in § 401(k)(12) or§ 401(m)(11). The plans in Situation 2,Situation 3 and Situation 4 do not meetthe requirements of § 416(g)(4)(H) and are

therefore subject to the top-heavy rules in§ 416 for 2004.

DRAFTING INFORMATION

The principal author of this revenue rul-ing is Roger Kuehnle of the EmployeePlans, Tax Exempt and Government Enti-ties Division. For further information re-garding this revenue ruling, please con-tact Employee Plans’ taxpayer assistancetelephone service at 1–877–829–5500 (atoll-free number), between the hours of8:00 a.m. and 6:30 p.m. Eastern Time,Monday through Friday. Mr. Kuehnlemay be reached at 1–202–283–9888 (nota toll-free number).

Section 457.—DeferredCompensation Plansof State and LocalGovernments andTax-Exempt Organizations

Whether amounts attributable to rollovers that areaccounted for separately are subject to the section 457plan’s general distribution requirements. See Rev.Rul. 2004-12, page 478.

Section 894.—IncomeAffected by Treaty26 CFR 1.894–1: Income affected by treaty.

Service partnerships. This ruling pro-vides guidance concerning the applicationof the U.S.-Germany income tax treaty toa nonresident partner in a service partner-ship that conducts activities in the UnitedStates. It makes clear that a nonresidentpartner is subject to U.S. income tax onhis share of income from the partnership tothe extent that such income is attributableto the partnership’s activities in the UnitedStates, without regard to whether the part-ner performs services in the United States.This ruling also applies to other U.S. in-come tax treaties that have the same orsimilar provisions as those in the U.S.-Ger-many treaty.

Rev. Rul. 2004–3

ISSUE

Whether a nonresident partner in a ser-vice partnership that has a fixed base inthe United States is subject to U.S. taxon income attributable to that fixed base

February 17, 2004 486 2004-7 I.R.B.

under Article 14, Independent PersonalServices, of the Convention Between theUnited States of America and the FederalRepublic of Germany for the Avoidanceof Double Taxation and the Prevention ofFiscal Evasion with Respect to Taxes onIncome and Capital and to Certain OtherTaxes, signed on August 29, 1989, asamended by the Protocol signed on thesame date (the “Treaty”).

FACTS

P is a service partnership that is orga-nized under the laws of Germany. P hasoffices in Germany and the United States.Its U.S. office is a fixed base under Arti-cle 14 of the Treaty. P is comprised of twopartners: A, a nonresident alien individualwho is a resident of Germany under Arti-cle 4 of the Treaty, and B, a U.S. resident.A performs services solely at P’s office inGermany and B performs services solelyat P’s office in the United States. A and Bagree to divide the profits of the partner-ship equally.

LAW AND ANALYSIS

Under section 701 of the Internal Rev-enue Code (the “Code”), a partnership isnot subject to income tax; rather, the per-sons carrying on the business of the part-nership as partners are liable for incometax in their separate or individual capaci-ties. Code section 702 requires a partnerto determine its income tax by separatelytaking into account its distributive shareof the partnership’s income. Under sec-tion 702(b), the character of an item of in-come, gain, loss, deduction, or credit is de-termined as if such item were realized di-rectly from the source from which it wasrealized by the partnership, or incurred inthe same manner as incurred by the part-nership. Under Code section 704, a part-ner’s distributive share generally is deter-mined by the partnership agreement unlessan allocation under the agreement does nothave substantial economic effect.

Under section 875(1) of the Code, anonresident alien individual who is a part-ner in a partnership that is engaged in aU.S. trade or business is himself consid-ered to be so engaged. Section 871(b)(1)of the Code provides that a nonresidentalien individual is taxable under Code sec-tions 1 or 55 on his taxable income that is

effectively connected with the conduct ofa U.S. trade or business.

Section 894(a)(1) states that the provi-sions of the Code shall be applied to anytaxpayer with due regard to any U.S. treatyobligation that applies to such taxpayer.In Donroy, Ltd. v. United States, 301 F.2d200 (9th Cir. 1962), the court held that theU.S. permanent establishment of a partner-ship was attributable to a foreign personthat was a limited partner under the 1942U.S.-Canada income tax treaty. In Ungerv. Commissioner, 936 F.2d 1316,1319(D.C. Cir. 1991), the court followed theholding in Donroy, noting that it stood forthe proposition that the office or perma-nent establishment of a partnership is, asa matter of law, the office of each of thepartners—whether general or limited. Seealso Johnston v. Commissioner, 24 T.C.920 (1955) (holding that a partnership’spermanent establishment is deemed tobe a permanent establishment of its part-ners); Rev. Rul. 90–80, 1990–2 C.B. 170(same).

Article 14 of the Treaty provides:

1. Income derived by an individual whois a resident of a Contracting Statefrom the performance of personalservices in an independent capacityshall be taxable only in that State,unless such services are performed inthe other Contracting State and theincome is attributable to a fixed baseregularly available to the individualin that other State for the purpose ofperforming his activities.

2. The term “personal services in anindependent capacity” includes butis not limited to independent scien-tific, literary, artistic, educational,or teaching activities as well as theindependent activities of physicians,lawyers, engineers, economists, ar-chitects, dentists, and accountants.

Applying Article 14 in the partner-ship context requires a determination ofwhether an individual partner in a servicepartnership who derives income attrib-utable to the fixed base of the servicepartnership in the other Contracting Stateis taxable on that income even thoughthe partner does not perform any servicesin the other Contracting State. Consis-tent with section 875 and the case law

discussed above, the fixed base of a part-nership is attributed to its partners forpurposes of applying Article 14 of theTreaty. Accordingly, A is treated as hav-ing a fixed base regularly available tohim in the United States. A is subject toU.S. net income taxation on his allocableshare of income from P to the extent thatsuch income is attributable to the fixedbase in the United States without regard towhether A performs services in the UnitedStates.

HOLDING

A is treated as having a fixed base reg-ularly available to him in the United Statesand is subject to U.S. net income taxationon his allocable share of income from Pto the extent that such income is attribut-able to P’s fixed base in the United States,without regard to whether A performs ser-vices in the United States. This holdingalso is applicable in interpreting other U.S.income tax treaties that contain provisionsthat are the same or similar to Article 14 ofthe Treaty.

DRAFTING INFORMATION

The principal author of this revenue rul-ing is Nina Chowdhry of the Office of As-sociate Chief Counsel (International). Forfurther information regarding this revenueruling, contact Nina Chowdhry at (202)622–3880 (not a toll-free call).

Section 1361.—SCorporation Defined

If the requirements of this revenue procedure aresatisfied, the Service will accept the position that acorporation’s S election is not affected when an ESOPdistributes stock of that corporation to a participant’sIRA in a direct rollover. See Rev. Proc. 2004-14,page 489.

Section 1362.—Election;Revocation; Termination26 CFR 1.1362–1: Election to be an S Corporation.

If the requirements of this revenue procedure aresatisfied, the Service will accept the position that acorporation’s S election is not affected when an ESOPdistributes stock of that corporation to a participant’sIRA in a direct rollover. See Rev. Proc. 2004-14,page 489.

2004-7 I.R.B. 487 February 17, 2004

Section 1366.—Pass-Thruof Items to Shareholders

If the requirements of this revenue procedure aresatisfied, the Service will accept the position that acorporation’s S election is not affected when an ESOPdistributes stock of that corporation to a participant’sIRA in a direct rollover. See Rev. Proc. 2004-14,page 489.

Section 4975.—Tax onProhibited Transactions26 CFR 54.4975–7(b)(10): Put option.

If the requirements of this revenue procedure aresatisfied, the Service will accept the position that acorporation’s S election is not affected when an ESOPdistributes stock of that corporation to a participant’s

IRA in a direct rollover. See Rev. Proc. 2004-14,page 489.

February 17, 2004 488 2004-7 I.R.B.

Part III. Administrative, Procedural, and MiscellaneousDividends as a SeparatelyStated Item

Notice 2004–5

Section 772(a)(11) of the Internal Rev-enue Code provides that, in determiningthe income tax of a partner of an electinglarge partnership (ELP), the partner shalltake into account separately the partner’sdistributive share of partnership items(in addition to those listed in § 772(a)(1)through (10)) to the extent that the Secre-tary determines that the separate treatmentof these items is appropriate.

Pursuant to this authority, the Secretaryhas determined that it is appropriate for apartner of an ELP to take into account sep-arately the partner’s distributive share ofthe partnership’s dividends received thatare qualified dividend income (QDI) as de-fined in § 1(h)(11)(B). This requirement toseparately account for QDI takes into ac-count the changes in the taxation of QDIunder § 302 of the Jobs and Growth TaxRelief Reconciliation Act of 2003, Pub. L.No. 108–27, 117 Stat. 752. This require-ment is effective for dividends received bya partnership after December 31, 2002.

The principal author of this noticeis Bradford R. Poston of the Office ofAssociate Chief Counsel (Passthroughsand Special Industries). For further in-formation regarding this notice, contactBradford R. Poston at (202) 622–3060(not a toll-free call).

26 CFR 1.1362–2: Termination of election.(Also Part I, §§ 401, 402, 409, 1361, 1362, 1366,4975; 1.401(a)(31)–1; 1.1362–1; 54.4975–7(b)(10).)

Rev. Proc. 2004–14

SECTION 1. PURPOSE

The Treasury Department and the Inter-nal Revenue Service have determined thatit is consistent with the purposes of, andpolicies underlying, employee stock own-ership plans (ESOPs) to enable an ESOPto direct certain rollovers of distributionsof S corporation stock to an individual re-tirement plan (IRA) in accordance with a

distributee’s election without terminatingthe corporation’s S election. Accordingly,if the requirements of this revenue proce-dure are satisfied, the Service will acceptthe position that a corporation’s S electionis not affected when an ESOP distributesstock of that corporation to a participant’sIRA in a direct rollover.

Rev. Proc. 2003–23, 2003–1 C.B. 599,provides that the Service will accept theposition that an S corporation’s election isnot affected as a result of an ESOP’s dis-tribution of S corporation stock in a directrollover to an IRA if the terms of the ESOPrequire that the S corporation repurchaseits stock immediately upon the ESOP’sdistribution of the stock to the IRA, the Scorporation actually repurchases the stock,and the other requirements of that revenueprocedure are satisfied. This revenue pro-cedure modifies Rev. Proc. 2003–23 byproviding that the Service also will ac-cept the position that an S corporation’selection is not affected as a result of anESOP’s distribution of S corporation stockin a direct rollover to an IRA if the termsof the ESOP require that the S corpora-tion repurchase its stock immediately uponthe ESOP’s distribution of the stock to theIRA, the ESOP is permitted to assume therights and obligations of the S corporationto repurchase the S corporation stock im-mediately upon the ESOP’s distribution ofthe stock to an IRA, the ESOP repurchasesthe stock, and the other terms of this rev-enue procedure are satisfied.

SECTION 2. BACKGROUND

In 1996, Congress amended§ 1361(b)(1)(B) of the Internal Rev-enue Code to make ESOPs (as definedin § 4975(e)(7)), along with other plansqualified under § 401(a), eligible Scorporation shareholders. A fundamentalpurpose of an ESOP, including an ESOPthat holds stock in an S corporation, is toprovide participants with equity owner-ship in the employer corporation throughparticipation in the ESOP, includingdistributions of employer securities toparticipants. See S. Rep. 94–938 at 180,1976–3 C.B. 218 (stating that an ESOP “isa technique of corporate finance designedto build beneficial equity ownership of

shares in the employer corporation in itsemployees”).

Section 409(h) generally requires thatan ESOP provide for distributions in theform of employer securities. An ESOPmeets the requirements of § 409(h)(1)(A)and (B) if a participant who is entitled toa distribution has the right to demand thatthe participant’s benefits be distributed inthe form of employer securities and, if theemployer securities are not readily trade-able on an established securities market,has a right to require that the employer re-purchase the securities under a fair valua-tion formula. This right is commonly re-ferred to as a “put option.” The put op-tion must permit a participant to put the se-curity to the employer in accordance with§ 409(h) and § 54.4975–7(b)(10) of the Ex-cise Tax Regulations. However, under nocircumstances may the put option bind theESOP. The put option may grant the ESOPan option to assume the rights and obliga-tions of the employer to repurchase the se-curities at the time that the put option isexercised.

Section 409(h)(2)(B) provides that anESOP maintained by an S corporation ispermitted to provide for distributions onlyin cash or for distributions of employersecurities subject to a repurchase require-ment which meets the requirements of§ 409(h)(1)(B).

Under § 401(a)(31) and A–1 of§ 1.401(a)(31)–1 of the Income Tax Reg-ulations, a qualified plan, including anESOP, is required to permit the distribu-tee of any eligible rollover distribution(as defined in § 402(c)(4)) to have thedistribution paid in a direct rollover (asdefined in A–3 of § 1.401(a)(31)–1) toan eligible retirement plan (as definedin § 402(c)(8)(B)) specified by the dis-tributee. Therefore, an ESOP that holdsS corporation stock and permits distribu-tions in the form of employer securitiesis required to permit participants to electto have any distribution of S corporationstock that is an eligible rollover distri-bution be paid in a direct rollover to aneligible retirement plan specified by thedistributee, including an IRA. An IRAtrustee or custodian, however, is not a per-missible S corporation shareholder. See§§ 1361(b) and 1361(c)(6).

2004-7 I.R.B. 489 February 17, 2004

Under § 409(h)(2)(B), an ESOP thatprovides for distributions in the form of se-curities of an employer that is an S cor-poration is permitted to provide that the Scorporation stock included in the distribu-tion is subject to a repurchase requirement.Thus, an ESOP is permitted to provide thatany stock in an S corporation that is dis-tributed is subject to immediate repurchaseby the S corporation upon a direct rolloverof the stock from the ESOP to an IRA.

SECTION 3. SCOPE

This revenue procedure sets forth cer-tain requirements related to an ESOP’s dis-tribution of S corporation stock to a partic-ipant where the participant elects to havethe S corporation stock distributed to anIRA in a direct rollover. If these require-ments are satisfied, the Service will acceptthe position that the distribution does notaffect the S corporation’s election to betaxed as an S corporation.

SECTION 4. APPLICATION

The Service will accept the position thatan S corporation’s election is not affectedas a result of an ESOP’s distribution ofS corporation stock where the participantdirects that such stock be distributed to anIRA in a direct rollover, provided that:

.01 The terms of the ESOP require thatthe S corporation repurchase the stock im-mediately upon the ESOP’s distribution ofthe stock to an IRA;

.02 Either, pursuant to the terms of theESOP, the S corporation actually repur-chases the S corporation stock contempo-raneously with, and effective on the sameday as, the distribution, or, pursuant to theterms of the ESOP, the ESOP is permittedto assume the rights and obligations of theS corporation to repurchase the S corpora-tion stock immediately upon the ESOP’sdistribution of the stock to an IRA and theESOP actually repurchases the S corpo-ration stock contemporaneously with, andeffective on the same day as, the distribu-tion; and

.03 No income (including tax-exemptincome), loss, deduction, or credit attribut-able to the distributed S corporation stockunder § 1366 is allocated to the partici-pant’s IRA.

SECTION 5. EFFECT ON OTHERREVENUE PROCEDURES

Rev. Proc. 2003–23 is modified andsuperseded.

SECTION 6. DRAFTINGINFORMATION

The principal authors of this rev-enue procedure are Audrey W. Ellis ofthe Office of Associate Chief Counsel(Passthroughs and Special Industries),John Ricotta of the Office of DivisionCounsel/Associate Chief Counsel (TaxExempt and Government Entities) andRobert Gertner of the Employee Plans,Tax Exempt and Government Entities Di-vision. For further information regardingthe S corporation aspects of the revenueprocedure, contact Ms. Ellis at (202)622–3060 (not a toll-free call). For furtherinformation regarding the employee plansaspects of the revenue procedure, contactthe Employee Plans’ taxpayer assistancetelephone service at 1–877–829–5500 (atoll-free call) between the hours of 8:00a.m. and 6:30 p.m. Eastern Time, Mondaythrough Friday or contact Mr. Gertner at(202) 283–9888 (not a toll-free call).

26 CFR 601.201: Rulings and determination letters.(Also Part I, § 412.)

Rev. Proc. 2004–15

SECTION 1. PURPOSE

The purpose of this revenue procedureis to outline the procedures of the Inter-nal Revenue Service with respect to appli-cations for waivers of the minimum fund-ing standard under either § 412(d) of theInternal Revenue Code or section 303 ofthe Employee Retirement Income SecurityAct of 1974 (ERISA), Pub. L. 93–406,1974–3 C.B. 1, 41.

SECTION 2. REQUESTS FORWAIVERS OF THE MINIMUMFUNDING STANDARD FORDEFINED BENEFIT PLANS

.01 Submission.—Requests for waiversof the minimum funding standard for de-fined benefit plans must be submitted to:

Employee PlansInternal Revenue ServiceCommissioner, TE/GEAttention: SE:T:EP:RAP.O. Box 27063McPherson StationWashington, D.C. 20038

The user fee required by Rev. Proc.2004–8, 2004–1 I.R.B. 240, or its succes-sors, must be sent with such requests.

.02 Necessary Procedural Docu-ments.—A request will not be consideredunless it complies with (1) through (5)below.

(1) The request must be signed by thetaxpayer maintaining the plan (hereinafterreferred to as “applicant”) or an authorizedrepresentative of the applicant who eithermust be identified in (a), (b), or (c) ofsubsection 9.02(11) of Rev. Proc. 2004–4,2004–1 I.R.B. 125, or must be an en-rolled actuary within the meaning of§ 7701(a)(35) of the Code. Where an au-thorized representative signs the request orwill appear before the Service in connec-tion with the request, a Form 2848, Powerof Attorney and Declaration of Represen-tative, must be submitted with the request.For multiemployer plans, the request mustbe made by the Board of Trustees (whichshall be deemed to be the applicant) or byan authorized representative of the Boardof Trustees. An individual is not an au-thorized representative of the applicantmerely on account of being the adminis-trator or trustee of the plan.

(2) The request also must contain adeclaration in the following form: “Un-der the penalties of perjury, I declare that Ihave examined this request, including ac-companying documents, and to the best ofmy knowledge and belief, the facts pre-sented in support of the request are true,correct, and complete.” This declarationmust be signed by the applicant (e.g., anauthorized officer of a corporation). Thesignature of an individual with a power ofattorney will not suffice for the declara-tion. See section 9.02(13) of Rev. Proc.2004–4, supra, p. 142.

(3) Because a request for a waiver con-stitutes a request for a ruling, compliancewith § 6110 of the Code is also required.Section 601.201 of the Statement of Pro-cedural Rules sets forth the requirements

February 17, 2004 490 2004-7 I.R.B.

applicable to requests for rulings and de-termination letters which are subject to§ 6110. Section 601.210(e) furnishes spe-cific instructions to applicants. The appli-cant must also pay the user fee required byRev. Proc. 2004–8 or its successors.

The applicant must provide with the re-quest either a statement of proposed dele-tions and the statutory basis for eachproposed deletion, or a statement that noinformation other than names, addresses,and taxpayer identifying numbers need bedeleted.

(4) The applicant must provide a copyof a written notification that an applica-tion for a waiver of the minimum fundingstandard under § 412(d) of the Code hasbeen submitted to the Service. The origi-nal of the written notification must bear asignature by an appropriate officer of theapplicant and must be in substantially theform set forth in the Model Notice foundin the Appendix A to this revenue proce-dure. The Service does not require the ap-plicant to furnish any information in addi-tion to that required by the Model Notice inthe Appendix A to plan participants, ben-eficiaries, alternate payees, or employeeorganizations as part of the waiver appli-cation process, but additional informationmay, of course, be provided by the appli-cant pursuant to the collective bargainingprocess or otherwise.

The application must state that such noticewas hand delivered or mailed to the lastknown address of each employee organiza-tion, participant, beneficiary, and alternatepayee (within the meaning of § 414(p)(8)of the Code) within 14 days prior to thedate of the application. If the applicantmakes a reasonable effort to carry out theprovisions of this paragraph, failure of anemployee organization, participant, bene-ficiary, or alternate payee to receive thenotice will not cause the applicant to failthe notice requirement. However, merelyposting the notice on a bulletin board is notsufficient to satisfy this requirement.

.03 Necessary Waiver Informa-tion.—The applicant must furnish ap-propriate evidence that the employer andall other entities included within the con-trolled group of which the employer is amember are unable to satisfy the minimumfunding standard for a plan year without

temporary substantial business hardshipand that application of the standard wouldbe adverse to the interest of plan partic-ipants in the aggregate. In the case of amultiemployer plan, the applicant mustfurnish appropriate evidence that 10 per-cent or more of the number of employerscontributing to or under the plan are unableto satisfy the minimum funding standardfor a plan year without substantial busi-ness hardship and that application of thestandard would be adverse to the interestof plan participants in the aggregate. Whatconstitutes appropriate evidence will de-pend on the facts and circumstances ofeach case. A response must be furnishedfor each of the subsections (1) through (7)below. In certain cases some of the mate-rial described in subsections (1) through(7) may be inapplicable, unavailable, in-appropriate or burdensome to furnish. Insuch cases, the applicant should furnisha statement indicating why the materialfor a particular subsection is inapplicable,unavailable, inappropriate or burdensome.

(1) General facts concerning the em-ployer.

A brief statement should be submittedconcerning: (a) the history of the em-ployer and its primary business; (b) theownership of the employer and any re-cent or contemplated changes (such asacquisitions, mergers, discontinuances ofoperations) which might have a bearingon the employer’s organization or finan-cial condition; (c) whether the employeris aggregated with any other entity forpurposes of §§ 414(b), (c), (m) or (o) ofthe Code; and (d) whether the plan is alsomaintained by employers described in (c)above or any other employers.

(2) The financial condition of the em-ployer.

The annual financial report of the em-ployer and each of the other entitiesincluded within the controlled group ofwhich the employer is a member for eachof the two fiscal years that commencedprior to any plan year for which a waiver isrequested and the annual financial reportfor each fiscal year that commenced withor within each plan year for which a waiveris requested must be submitted. This sub-mission must include at least the balance

sheet, profit and loss statement, cash flowstatement, and notes to the financial state-ment. Recent interim financial reportsfor each of the controlled group mem-bers, if available, should also be submittedalong with an interim financial reportcovering the corresponding period for theprevious year. If the employer submitsfinancial reports to the Securities and Ex-change Commission, these reports shouldbe submitted for the same periods as theannual financial reports. Preferably, thefinancial report should include certifiedfinancial statements. If certified financialstatements have not been prepared, anuncertified report is acceptable. If nei-ther certified nor uncertified reports areavailable, copies of the company’s federalincome tax returns, including all of thesupporting schedules, must be submitted.(See also paragraph 5.)

(3) Executive compensation arrange-ments (not required for multiemployerplans)

For each person who is an officer (withinthe meaning of Q&A T–13 of § 1.416–1of the Income Tax Regulations) or direc-tor of the applicant or any entity aggre-gated with the applicant for purposes of§§ 414(b), (c), (m), or (o) of the Code(“aggregated entities”), provide a detailedstatement concerning all amounts that theapplicant or any aggregated entity has paidor will pay to or for the benefit of suchperson during the plan year for which therequest is made and the immediately pre-ceding 24 months. For this purpose, if thenumber of employees (including part-timeemployees) of the applicant and all aggre-gated entities as of the first day of the planyear for which the request is made is: (a)not more than 30, no more than three per-sons shall be treated as officers; (b) morethan 30 but not more than 100, no morethan 10% of such employees (rounded tothe next integer) shall be treated as offi-cers; or (c) more than 100, no more than10 of such employees shall be treated asofficers. In each case, this limited num-ber of officers shall be comprised of thoseofficers to whom or for whose benefit theapplicant and all aggregated entities havepaid or will pay the largest such amountsduring such period. In addition, provideinformation concerning amounts paid orto be paid during such period to or for

2004-7 I.R.B. 491 February 17, 2004

the benefit of up to five additional personswho are former officers or directors of theapplicant or any aggregated entity or whoare aggregated with any such former offi-cer or director for purposes of §§ 414(b),(c), (m) or (o) of the Code and who wouldbe included in such limited number of offi-cers if they were officers of the applicant.

The statement should include, among otherpayments, amounts paid with respect to:(a) salary; (b) non–qualified deferred com-pensation; (c) fringe benefits, perquisites,and other personal benefits; (d) bonusesand incentive compensation, includingamounts deferred from previous periods;(e) money or other property set aside inany trust, escrow, insurance policy, orother similar funding vehicle during theyears in question for the benefit of anysuch person, whether or not included insuch person’s income; (f) grants of stockoptions, restricted stock, or other equitycompensation; (g) money or other propertypaid by reason of the exercise of any stockoption or stock appreciation right or pur-suant to any phantom stock plan or agree-ment; (h) money or other property paidpursuant to any other long-term incentiveplan; (i) loans to or for the benefit of suchpersons and any loan repayments duringsuch period; (j) money or other propertypaid in connection with any change incontrol or termination of employment orservice and (k) any other compensationto or for the benefit of such persons thathas affected or will affect the cash flowof the applicant or any aggregated entityfor such period. Applicants may omit in-formation regarding any plan that satisfiesthe qualification requirements of § 401(a)of the Code and any other pension, profitsharing, employee stock ownership, em-ployee stock purchase, group life, health,hospitalization, medical reimbursement,fitness or wellness, employee relocation,severance, or similar plan that does notdiscriminate in scope, terms, or operationin favor of officers or directors of the ap-plicant and that is available generally toall salaried employees.

(4) Nature and extent of the businesshardship. An explanation of the natureand extent of the business hardship shouldinclude the following.

(a) A discussion of the underlyingreasons which have led to the current situ-ation (such as declining sales, unexpectedlosses, labor disputes, etc.).

(b) A statement concerning theprospects for recovery, including reasonswhy such recovery is likely.

(c) A statement describing the ac-tions taken or planned to effect recovery.

(d) A statement as to when and towhat extent it is anticipated that requiredcontributions to the plan can reasonably beexpected to resume.

(e) Financial projections and col-lateral information for certain employers(not required for multiemployer plans)

If the sum of the outstanding balances ofany amortization bases established under§ 412(b)(2)(C) of the Code for waiversgranted to the plan for any prior planyears (calculated as of the first day of theplan year for which a new waiver is be-ing requested) when added to the amountfor which a waiver is currently being re-quested, equals or exceeds $1,000,000,items (4)(b) & (c) should be supportedby financial projections, for not less thanthe next five years, for each trade or busi-ness of the plan sponsor, along with anysupporting text and schedules. Theseprojections should include revenues, ex-penses, and cash flow statements, alongwith all major strategic and economicassumptions used in deriving them. Thecash flow projections should include cap-ital expenditures, forecasted contributionsto the pension plan(s), long-term debtrepayments, and any mandatory debt re-payments. Any projections based on a sig-nificant strategic or financial turnaroundshould fully explain this turnaround. Also,a brief description should be includedof what collateral, if required, would beavailable to secure any waived contribu-tions.

The Service may request additional in-formation, including items listed in§ 412(d)(2) of the Code.

(5) Facts concerning the pension plan.For each pension plan for which a waiveris requested, the following informationshould be supplied.

(a) The name of the plan, theplan’s identification number, and filefolder number (if any).

(b) The date the plan was adopted.

(c) The effective date of the plan.

(d) The classes of employees cov-ered. If the only participants are ownersof the employer or relatives of owners, sostate.

(e) The number of employeescovered.

(f) A copy of the current plan doc-ument and the most recent summary plandescription.

(g) A brief description of all planamendments adopted during the year forwhich the waiver is requested and the pre-vious four years which affect plan costs,including the approximate effect of eachamendment on such costs.

(h) The most recent actuarial re-port plus any available actuarial reports forthe preceding two plan years. Also, if notshown in that report, the present value ofaccrued benefits, present value of vestedbenefits, and fair market value of assets(excluding contributions not yet paid).

(i) How the plan is funded (i.e.,trust fund, individual insurance policies,etc.).

(j) A list of the contributionsactually paid in each month, from thetwenty–fourth month prior to the begin-ning of the plan year for which the waiveris requested through the date of the requestand the plan year to which the contribu-tions were applied, with the employeecontributions and the employer contribu-tions listed separately.

(k) The plan year for which thewaiver is requested (e.g., 1/1/03–12/31/03).

(l) The approximate contributionrequired to meet the minimum fundingstandard and the approximate amount re-quested to be waived. For defined benefitplans, this amount should be determinedby the plan’s enrolled actuary.

February 17, 2004 492 2004-7 I.R.B.

(m) A copy of the most recentlycompleted Annual Return/Report of Em-ployee Benefit Plan (Form 5500 series, asapplicable) and in the case of a definedbenefit plan, a copy of the correspondingActuarial Information schedule (ScheduleB of Form 5500).

(n) Whether the plan is subject toTitle IV of ERISA.

(o) A copy of each ruling letterthat waived the minimum funding stan-dard during the last 15 plan years, a state-ment of the amount waived for each planyear, and a statement of the outstandingbalance of the amortization base for eachwaived funding deficiency. The outstand-ing balance of the amortization base foreach waiver is to be calculated as of thefirst day of the plan year for which a waiveris being requested.

(6) Other pension, profit–sharing, orstock bonus plans. If the employer main-tains more than one plan, an outline of theessential facts for each such plan should besubmitted. This should include:

(a) A brief description of the plan,including the name of the plan and its planyear.

(b) The number of employeescovered.

(c) The classes of employees cov-ered.

(d) The approximate annual con-tribution required.

(e) The amount of contributionsthat have been made, or are intended to bemade, for any plan year of such other plancommencing in, or ending in, the plan yearfor which the waiver is requested.

(f) A statement as to whether awaiver request is contemplated for theplan.

(7) Other information.

(a) Describe the nature of anymatters pertaining to the plan which arecurrently pending or are intended to besubmitted to the Service, Department ofLabor or the Pension Benefit GuarantyCorporation.

(b) Furnish details of any existingarbitration, litigation, or court procedurewhich involves the plan.

(c) Also state which Area Officemaintains files concerning the plan.

(8) Although it is not required, a digestof certain information from the financialstatements described in this section will fa-cilitate the processing of a waiver request.For example, a digest could show for theapplicable years:

(a) current assets;

(b) inventory included in currentassets;

(c) fixed assets;

(d) other assets;

(e) total assets;

(f) current liabilities;

(g) long–term liabilities;

(h) other liabilities;

(i) total liabilities;

(j) working capital;

(k) equity;

(l) sales;

(m) cost of sales;

(n) gross profit;

(o) other income and expense;

(p) net profit before taxes;

(q) income taxes;

(r) net profit after taxes; and

(s) for plans for which waivers arerequested, pension costs expensed in deter-mining (p).

.04 Additional Copy of Information Re-quired.—The applicant must furnish twocopies of the necessary waiver informationdescribed in section 2.03, if the sum of theoutstanding balances of any amortizationbases established under § 412(b)(2)(C) ofthe Code for waivers granted to the planfor any prior plan years (calculated as of

the first day of the plan year for whicha new waiver is being requested) whenadded to the amount for which a waiveris currently being requested, equals or ex-ceeds $1,000,000.

.05 Checklist.—A checklist has beenprovided in Appendix B for the conve-nience of the taxpayer submitting the re-quest. In certain cases some of the mate-rial described above may be inappropriateor burdensome to furnish. In such cases,the request for approval should include astatement indicating why such material isnot being furnished.

SECTION 3. REQUEST FORWAIVERS FOR DEFINEDCONTRIBUTION PENSION PLANS

.01 Background Information.—Section3 of Rev. Rul. 78–223, 1978–1 C.B.125, requires that a defined contributionpension plan contain certain provisions inorder for a waiver to be granted. If theapplicant does not want to draft individ-ually designed provisions to satisfy therequirements of section 3 of Rev. Rul.78–223, the Service will provide sampleplan amendment language that complieswith such requirements. See subsection.02. However, a provision that satisfiessection 3 of Rev. Rul. 78–223 does notnecessarily satisfy the requirements of§ 401(a) of the Code. In order to providemaximum flexibility in obtaining a waiverfor a defined contribution pension plan,three alternative procedures are providedin subsections .02, .03, and .04, in whicha single request may cover either a waiverruling only or a waiver ruling and a de-termination letter as to the status under§ 401(a) of the Code.

.02 Waiver Ruling Only/Without Sub-mission of Plan Amendment.—Under thisprocedure, requests for waivers must besubmitted to:

Employee PlansInternal Revenue ServiceCommissioner, TE/GEAttention: SE:T:EP:RAP.O. Box 27063McPherson StationWashington, D.C. 20038

The applicant must satisfy the require-ments of section 2 of this revenue proce-dure except those applicable only to de-fined benefit plans, e.g. section 2.03(5)(h).

2004-7 I.R.B. 493 February 17, 2004

Any waiver ruling granted under this pro-cedure will be accompanied by a planamendment supplied by the Service whichwill, if adopted, satisfy section 3 of Rev.Rul. 78–223. The waiver will be condi-tioned upon the plan being amended byadoption of that amendment, within a rea-sonable period of time, and will containa caveat stating that the ruling is not aruling as to the effect the plan provisionmay have on the qualified status of theplan. Upon receipt of that amendment,the applicant may (within 60 days of dateof the letter) request reconsideration ofthis waiver condition if the amendmentis inappropriate. Reconsideration may berequested by submitting a letter from theapplicant (or authorized representative) tothe above address.

.03 Waiver Ruling Only/With Submis-sion of Plan Amendment.—Under thisprocedure, requests for waivers must besubmitted to:

Employee PlansInternal Revenue ServiceCommissioner, TE/GEAttention: SE:T:EP:RAP.O. Box 27063McPherson StationWashington, D.C. 20038

The applicant must satisfy the require-ments of section 2 of this revenue proce-dure, except those applicable only to de-fined benefit plans, e.g. section 2.03(5)(h),and must include the plan provisions nec-essary to satisfy section 3 of Rev. Rul.78–223. All waivers issued pursuant tothis subsection will contain a caveat indi-cating that the ruling is not a ruling as tothe effect any plan provision, submittedpursuant to the previous sentence, mayhave on the qualified status of the plan.

.04 Waiver Ruling and DeterminationLetter Request.—Under this procedureboth the request for a waiver ruling andthe request for a determination letter onthe effect of any amendment necessaryto satisfy section 3 of Rev. Rul. 78–223must be submitted by the applicant to theOffice of the Commissioner, Tax Exemptand Government Entities Division whereit will be treated as if it had been submittedas a request for technical advice from theDeterminations Manager.

(1) The request that is submitted to theOffice of the Commissioner, Tax Exemptand Government Entities Division must in-clude the following:

(a) The combined request mustsatisfy all the procedural requirementsdescribed in section 3.03 of this revenueprocedure;

(b) The submission must includea completed Form 5300 and all necessarydocuments, plan amendments, and infor-mation required by the Form 5300 and bythis revenue procedure for approval of theplan amendments;

(c) The request must indicatewhich Area Office has audit jurisdictionover the return; and

(d) The user fee for both thewaiver request and the determination letterrequest must be contained in the submis-sion to the Office of the Commissioner,Tax Exempt and Government Entities Di-vision.

(2) The procedures for notice andcomment by interested parties, which arecontained in sections 17, 18, and 19, ofRev. Proc. 2004–6, 2004–1 I.R.B. 197,or its successors, as well as the notice andcomment procedures provided in section2.02 of this revenue procedure must besatisfied. Comments are to be forwardedto the Determinations Office that is con-sidering the determination letter requestfor the plan amendments.

(3) The waiver request will be handledby the Office of the Commissioner, TaxExempt and Government Entities Divisionas follows:

(a) The waiver request and sup-porting documents will be forwarded to theActuarial Group, SE:T:EP:RA:T:A, whichwill treat the request as a technical ad-vice on the qualification issue with respectto the plan provisions necessary to satisfysection 3 of Rev. Rul. 78–223.

(b) The appropriate Determina-tions Office will be notified of the request.In order not to delay the processing of therequest, all materials relating to the deter-mination letter request will be sent by theOffice of the Commissioner, Tax Exempt

and Government Entities Division to theDeterminations Manager for considera-tion while the technical advice request iscompleted.

(c) The Office of the Commis-sioner, Tax Exempt and Government Enti-ties Division will consider both issues. Ifa waiver is to be granted and if the Officeof the Commissioner, Tax Exempt andGovernment Entities Division believesthat qualification of the plan is not ad-versely affected by the plan amendment,a technical advice memorandum will beissued to the Determinations Manager.The Determinations Manager must decidewithin 10 working days from the date ofthe technical advice memorandum eitherto furnish the applicant with the technicaladvice memorandum and with a favor-able advance determination letter, or toask for reconsideration of the technicaladvice memorandum. This request mustbe in writing. An initial written notice ofintent to make this request may be sub-mitted within 10 working days of the dateof the technical advice memorandum andfollowed by a written request within 30working days from the date of such writ-ten notice. If the Determinations Managerdoes not ask for reconsideration of thetechnical advice memorandum within 10working days, the Actuarial Group willissue the waiver ruling. This ruling willnot contain the caveat described in section3.02.

SECTION 4. DEADLINE FORREQUESTING A WAIVER

All waiver requests (for plans other thanmultiemployer plans) must be submittedno later than the 15th day of the 3rd monthfollowing the close of the plan year forwhich the waiver is requested. The Ser-vice cannot extend this statutory deadline.A request for a waiver with respect to amultiemployer plan generally must be sub-mitted no later than the close of the planyear following the plan year for which thewaiver is requested.

In seeking a waiver with respect to aplan year which has not yet ended, the ap-plicant may have difficulty in furnishingsufficient current evidence in support ofthe request. For this reason it is gener-ally advised that a request not be submit-ted earlier than 180 days prior to the end

February 17, 2004 494 2004-7 I.R.B.

of the plan year for which the waiver is re-quested.

SECTION 5. GENERAL

Employers who have difficulty in fur-nishing the information specified in thisRevenue Procedure may call the Em-ployee Plans Customer Assistance Serviceat 1–877–829–5500 (a toll–free number),or write for guidance at the following ad-dress:

Internal Revenue ServiceCommissioner, TE/GEAttention: SE:T:EP:RA:T:A1111 Constitution Avenue, N.W.Washington, D.C. 20224

Additional information sent after the ini-tial request should be sent to the ActuarialGroup. In appropriate instances, prelim-inary conferences may be afforded in ad-dition to conferences available under Rev.Proc. 2004–4, 2004–1 I.R.B. 125.

SECTION 6. BANKRUPTCYPETITIONS

If the applicant or a significant num-ber of controlled group members file abankruptcy petition after the request for awaiver of the minimum funding standardis submitted to the Service, the applicantmust provide to the Service an update tothe information required to be submitted insection 2 of this revenue procedure, espe-cially the financial information in section2.03(4).

SECTION 7. EFFECTIVE DATE

This revenue procedure is effective forall ruling requests received after February

17, 2004, the date of its publication in theInternal Revenue Bulletin.

SECTION 8. EFFECT ON OTHERREVENUE PROCEDURES

Rev. Proc. 2004–4 is modified to theextent that this revenue procedure providesspecial procedures for issuing rulings withrespect to requests for waivers of the min-imum funding standard.

Rev. Proc. 2004–5 is modified to theextent that this revenue procedure providesspecial procedures for furnishing technicaladvice to Determinations managers whenboth a request for a waiver of the minimumfunding standard and a request for a deter-mination letter have been submitted for adefined contribution plan.

Rev. Proc. 2004–6 is modified to theextent that this revenue procedure providesspecial procedures to follow in issuing adetermination letter for a defined contribu-tion plan if a waiver of the minimum fund-ing standard has been requested.

Rev. Proc. 94–41, 1994–1 C.B. 711, issuperseded

SECTION 9. PAPERWORKREDUCTION ACT

The collection of information con-tained in this revenue procedure has beenreviewed and approved by the Office ofManagement and Budget in accordancewith the Paperwork Reduction Act (44U.S.C. § 3507) under control number1545–1873.

An agency may not conduct or sponsor,and a person is not required to respondto, a collection of information unless thecollection of information displays a validcontrol number.

The collection of information in thisrevenue procedure is in sections 2 and 3.This information is required to evaluateand process the request for a change infunding method. The collection of infor-mation is required to obtain approval fora change in funding method. The likelyrespondents are businesses or other for-profit institutions, nonprofit institutions,and small businesses and organizations.

The estimated total annual reportingburden is 4,730 hours.

The estimated annual burden per re-spondent varies from 75 to 100 hours,depending on individual circumstances,with an estimated average burden of 86hours. The estimated number of respon-dents and/or recordkeepers is 55.

The estimated annual frequency of re-sponses is one.

Books or records relating to a collectionof information must be retained as longas their contents may become material inthe administration of any internal revenuelaw. Generally, tax returns and tax returninformation are confidential, as requiredby 26 U.S.C. § 6103.

DRAFTING INFORMATION

The principal author of this revenueprocedure is John C. Heil of the EmployeePlans, Tax Exempt and Government En-tities Division. For further informationregarding how this revenue procedure ap-plies to employee plans matters, contactthe Employee Plans Customer AssistanceService at 1–877–829–5500 (a toll-freecall). Mr. Heil’s telephone number is(202) 283–9694 (not a toll-free call).

2004-7 I.R.B. 495 February 17, 2004

APPENDIX A

MODEL NOTICE OF FUNDING WAIVER APPLICATIONTO EMPLOYEE ORGANIZATIONS (UNIONS),

PARTICIPANTS, BENEFICIARIES, AND ALTERNATE PAYEES

This notice is to inform you that an application for a waiver of the minimum funding standard under § 412(d) of the InternalRevenue Code (Code) and section 303 of the Employee Retirement Income Security Act of 1974 (ERISA) has been submitted by[INSERT PLAN SPONSOR'S NAME] to the Internal Revenue Service (Service) for the [INSERT PLAN NAME] for the planyear beginning [INSERT DATE].

Under § 412(f)(4)(B) of the Code and section 303(e)(2) of ERISA, the Service will consider any relevant information submittedconcerning this application for a waiver of the minimum funding standard. You may send this information to the following address:

Director, Employee PlansInternal Revenue ServiceAttention: SE:T:EP:RA:T:A1111 Constitution Avenue, N.W.Washington, D.C. 20224

Any such information should be submitted as soon as possible after you have received this notice. Due to the disclosurerestrictions of § 6103 of the Code, the Service can not provide any information with respect to the waiver request itself.

In accordance with section 104 of ERISA and § 2520.104b–10 of the Department of Labor Regulations (29 C.F.R. Part 2520),annual financial reports for this plan, which include employer contributions made to the plan and the accumulated fundingdeficiency for the plan for any plan year, are available for inspection at the Department of Labor in Washington, D.C. Copies ofsuch reports may be obtained upon request and upon payment of copying costs from the following address:

Public Disclosure RoomRoom N–5507Employee Benefits Security AdministrationU.S. Department of Labor200 Constitution Avenue, N.W.Washington, D.C. 20210

As required by section 104(b)(2) of ERISA, copies of the latest annual plan report are available for inspection at the principaloffice of the plan administrator, who is located at [INSERT ADDRESS]. Copies of the annual report may be obtained uponrequest and upon payment of a copying charge of [INSERT CHARGE] by writing to the plan administrator at the above address.

The following information is provided pursuant to § 412(f)(4)(A) of the Code and section 303(e)(1) of ERISA:

Present Value of Vested Benefits $

Present Value of Benefits, calculated as though the plan terminated $

Fair Market Value of Plan Assets $

The above present values were calculated using an interest rate of [INSERT INTEREST RATE].

[SIGNATURE OF APPROPRIATE OFFICER OF THE PLAN SPONSOR][INSERT NAME][INSERT TITLE]

February 17, 2004 496 2004-7 I.R.B.

APPENDIX B

WAIVER OF MINIMUM FUNDING STANDARD REQUEST CHECKLISTIS YOUR SUBMISSION COMPLETE?

INSTRUCTIONS

The Service will be able to respond more quickly to your waiver of minimum funding standard request if it is carefully preparedand complete. To ensure your request is in order, use this checklist. Answer each question in the checklist by inserting Y for yes,N for no, or N/A for not applicable, as appropriate, in the blank next to the item. Sign and date the checklist (as taxpayer orauthorized representative) and place it on top of your request.

You must submit a completed copy of this checklist with your request. If a completed checklist is not submitted with your request,substantive consideration of your submission will be deferred until a completed checklist is received.

1. If you want to designate an authorized representative, have you included a properly executed Form 2848(Power of Attorney and Declaration of Representative)?

2. Have you satisfied all the requirements of Rev. Proc. 2003–4 or its successors (especially concerningsignatures and penalties of perjury statement)? (See section 2.02(1) & (2))

3. Have you included statement of proposed deletions? (See §2.02(3))

4. Have you included the user fee required under Rev. Proc. 2003–8 or its successors? (See section 2.01 &2.02(3))

5. Have you included a copy of the written notification that an application for a waiver has been submittedand a statement that such notice was delivered to each employee organization, participant, beneficiary andalternate payee? (See section 2.02(4) and Appendix A)

6. Have you included the general facts concerning the employer? (See section 2.03(1))

7. Have you included a description of the employer’s financial condition? (See section 2.03(2)).

8. If the plan is not a multiemployer plan, have you included a description of the employer’s executivecompensation arrangements? (See section 2.03(3))

9. Have you included an explanation of the nature and extent of the business hardship, including financialprojections if the waiver request exceeds $1,000,000 and the plan is not a multiemployer plan? (See sec-tion 2.03(4))

10. Have you included information concerning the pension plan? (See section 2.03(5))

11. Have you included information concerning other pension, profit-sharing, or stock bonus plans of theemployer? (See section 2.03(6))

12. Have you included information concerning other matters pertaining to the plan? (See section 2.03(7))

2004-7 I.R.B. 497 February 17, 2004

13. Have you provided a digest of financial information? (See section 2.03(8))

14. Have you provided 2 copies of the necessary waiver information described in section 2.03 if the waiverrequest exceeds $1,000,000? (See section 2.04)

15. If the waiver request pertains to a defined contribution pension plan, have you provided a copy of theplan amendment or determination letter request, if applicable? (See section 3.01–3.04)

16. Have you submitted the request for a waiver no later than the 15th day of the 3rd month followingthe close of the plan year if the plan is not a multiemployer plan, or no later than the close of the plan yearfollowing the plan year for which the waiver is requested if the plan is a multiemployer plan? (See section 4)

Signature Date

Title or Authority

Typed or printed name of person signing checklist

February 17, 2004 498 2004-7 I.R.B.

Part IV. Items of General Interest

Announcement of Disciplinary Actions InvolvingAttorneys, Certified Public Accountants, Enrolled Agents,and Enrolled Actuaries — Suspensions, Censures,Disbarments, and ResignationsAnnouncement 2004-6

Under Title 31, Code of Federal Regu-lations, Part 10, attorneys, certified publicaccountants, enrolled agents, and enrolledactuaries may not accept assistance from,or assist, any person who is under disbar-ment or suspension from practice beforethe Internal Revenue Service if the assis-tance relates to a matter constituting prac-tice before the Internal Revenue Serviceand may not knowingly aid or abet another

person to practice before the Internal Rev-enue Service during a period of suspen-sion, disbarment, or ineligibility of suchother person.

To enable attorneys, certified publicaccountants, enrolled agents, and enrolledactuaries to identify persons to whomthese restrictions apply, the Director, Of-fice of Professional Responsibility willannounce in the Internal Revenue Bulletin

their names, their city and state, their pro-fessional designation, the effective dateof disciplinary action, and the period ofsuspension. This announcement will ap-pear in the weekly Bulletin at the earliestpracticable date after such action and willcontinue to appear in the weekly Bulletinsfor five successive weeks.

Disbarments From Practice Before the Internal RevenueService After Notice and an Opportunity for a Proceeding

Under Title 31, Code of Federal Regu-lations, Part 10, after notice and an oppor-

tunity for a proceeding before an adminis-trative law judge, the following individu-

als have been disbarred from practice be-fore the Internal Revenue Service:

Name Address Designation Effective Date

Baxley II, Milton Gainesville, FL CPA October 24, 2003

Consent Suspensions From Practice Before the InternalRevenue Service

Under Title 31, Code of Federal Regu-lations, Part 10, an attorney, certified pub-lic accountant, enrolled agent, or enrolledactuary, in order to avoid institution or con-clusion of a proceeding for his or her dis-barment or suspension from practice be-

fore the Internal Revenue Service, may of-fer his or her consent to suspension fromsuch practice. The Director, Office of Pro-fessional Responsibility, in his discretion,may suspend an attorney, certified publicaccountant, enrolled agent or enrolled ac-

tuary in accordance with the consent of-fered.

The following individuals have beenplaced under consent suspension frompractice before the Internal Revenue Ser-vice:

Name Address Designation Date of Suspension

Nietupski, John E. Springfield, MA Enrolled Agent IndefinitefromOctober 15, 2005

Roberts, Dennis C. Oklahoma City, OK Attorney IndefinitefromOctober 27, 2003

2004-7 I.R.B. 499 February 17, 2004

Name Address Designation Date of Suspension

Waldo-Grant, Barbara A. Grand Rapids, MI Enrolled Agent IndefinitefromNovember 1, 2003

Naylor, Dale C. El Cajon, CA Enrolled Agent IndefinitefromNovember 12, 2003

Schlude, Richard M. Wilkes Barre, PA Enrolled Agent IndefinitefromNovember 19, 2003

Stern, Samuel L. Robbinsdale, MN Attorney IndefinitefromNovember 19, 2003

Robles, Michael Dallas, TX CPA IndefinitefromDecember 1, 2003

Young Jr., Donald A. Redondo Beach, CA Enrolled Agent December 1, 2003toAugust 31, 2004

Hitchcock, William C. Irvine, CA Enrolled Agent IndefinitefromDecember 30, 2003

Willms, Bryant E. Lee Summit, MO Enrolled Agent January 1, 2004toDecember 31, 2004

Expedited Suspensions From Practice Before the InternalRevenue Service

Under Title 31, Code of Federal Regu-lations, Part 10, the Director, Office of Pro-fessional Responsibility, is authorized toimmediately suspend from practice beforethe Internal Revenue Service any practi-tioner who, within five years from the date

the expedited proceeding is instituted (1)has had a license to practice as an attor-ney, certified public accountant, or actuarysuspended or revoked for cause or (2) hasbeen convicted of certain crimes.

The following individuals have beenplaced under suspension from practice be-fore the Internal Revenue Service by virtueof the expedited proceeding provisions:

Name Address Designation Date of Suspension

Greene, Marvin Chicago, IL CPA IndefinitefromOctober 21, 2003

Bolusky, Eric B. Perkins, OK Attorney IndefinitefromOctober 21, 2003

Crutchfield Jr., Ernest Latty, OH Enrolled Agent IndefinitefromOctober 21, 2003

February 17, 2004 500 2004-7 I.R.B.

Name Address Designation Date of Suspension

Covey, Charles Gladstone, MO CPA IndefinitefromOctober 23, 2003

Prosperi, Arnold P. Jupiter Island, FL Attorney IndefinitefromNovember 24, 2003

Lucas, Christopher Overland Park, KS Attorney IndefinitefromNovember 24, 2003

Ramsey, Henry A. Burnet, TX CPA IndefinitefromDecember 15, 2003

Resignations of Enrolled AgentsUnder Title 31, Code of Federal Regu-

lations, Part 10, an enrolled agent, in or-der to avoid the institution or conclusionof a proceeding for his or her disbarmentor suspension from practice before the In-

ternal Revenue Service, may offer his orher resignation as an enrolled agent. TheDirector, Office of Professional Responsi-bility, in his discretion, may accept the of-fered resignation.

The Director, Office of ProfessionalResponsibility, has accepted offers of res-ignation as an enrolled agent from thefollowing individuals:

Name Address Date of Resignation

Pettyplace, Edward F. Sacramento, CA January 30, 2004

Guidance Under Section1502; Suspension of Losseson Certain Stock Dispositions;Correction

Announcement 2004–10

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Correction to final and tempo-rary regulations.

SUMMARY: This document corrects fi-nal and temporary regulations (T.D. 9048,2003–1 C.B. 644 [68 FR 12287]) pub-lished in the Federal Register on March14, 2003. The final and temporary reg-ulations redetermine the basis of stockof a subsidiary member of a consoli-dated group immediately prior to certaintransfers of such stock and certain decon-solidations of a subsidiary member andalso suspend certain losses recognized onthe disposition of stock of a subsidiarymember.

DATES: This document is effective onMarch 14, 2003.

FOR FURTHER INFORMATIONCONTACT: Aimee K. Meacham, (202)622–7530 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

The final and temporary regulations(T.D. 9048) that are the subject of thesecorrections are under section 1502 of theInternal Revenue Code.

Need for Correction

As published, the final and temporaryregulations (T.D. 9048) contain errorsthat may prove to be misleading and arein need of clarification. In particular,this document supplies text clarifying§ 1.1502–35T(c)((5)(i).

Correction of Publication

Accordingly, the publication of the finaland temporary regulations (T.D. 9048) thatwere the subject of FR. Doc. 03–6119, iscorrected as follows:

2004-7 I.R.B. 501 February 17, 2004

§ 1.1502–35T [Corrected]

1. On page 12294, column 1,§ 1.1502–35T(c)(5)(i), line 8 from thebottom of the paragraph, the language“subsidiary (or any successor) is not a”is corrected to read “subsidiary (and anysuccessor) is not a”.

La Nita Van Dyke,Acting Chief, Publications

and Regulations Branch,Legal Processing Division,

Associate Chief Counsel (Procedureand Administration).

(Filed by the Office of the Federal Register on January 12,2004, 8:45 a.m., and published in the issue of the FederalRegister for January 13, 2004, 69 F.R. 1918)

February 17, 2004 502 2004-7 I.R.B.

Definition of TermsRevenue rulings and revenue procedures(hereinafter referred to as “rulings”) thathave an effect on previous rulings use thefollowing defined terms to describe the ef-fect:

Amplified describes a situation whereno change is being made in a prior pub-lished position, but the prior position is be-ing extended to apply to a variation of thefact situation set forth therein. Thus, ifan earlier ruling held that a principle ap-plied to A, and the new ruling holds that thesame principle also applies to B, the earlierruling is amplified. (Compare with modi-fied, below).

Clarified is used in those instanceswhere the language in a prior ruling is be-ing made clear because the language hascaused, or may cause, some confusion.It is not used where a position in a priorruling is being changed.

Distinguished describes a situationwhere a ruling mentions a previously pub-lished ruling and points out an essentialdifference between them.

Modified is used where the substanceof a previously published position is beingchanged. Thus, if a prior ruling held that aprinciple applied to A but not to B, and thenew ruling holds that it applies to both A

and B, the prior ruling is modified becauseit corrects a published position. (Comparewith amplified and clarified, above).

Obsoleted describes a previously pub-lished ruling that is not considered deter-minative with respect to future transac-tions. This term is most commonly used ina ruling that lists previously published rul-ings that are obsoleted because of changesin laws or regulations. A ruling may alsobe obsoleted because the substance hasbeen included in regulations subsequentlyadopted.

Revoked describes situations where theposition in the previously published rulingis not correct and the correct position isbeing stated in a new ruling.

Superseded describes a situation wherethe new ruling does nothing more than re-state the substance and situation of a previ-ously published ruling (or rulings). Thus,the term is used to republish under the1986 Code and regulations the same po-sition published under the 1939 Code andregulations. The term is also used whenit is desired to republish in a single rul-ing a series of situations, names, etc., thatwere previously published over a period oftime in separate rulings. If the new rul-ing does more than restate the substance

of a prior ruling, a combination of termsis used. For example, modified and su-perseded describes a situation where thesubstance of a previously published rulingis being changed in part and is continuedwithout change in part and it is desired torestate the valid portion of the previouslypublished ruling in a new ruling that is selfcontained. In this case, the previously pub-lished ruling is first modified and then, asmodified, is superseded.

Supplemented is used in situations inwhich a list, such as a list of the names ofcountries, is published in a ruling and thatlist is expanded by adding further names insubsequent rulings. After the original rul-ing has been supplemented several times, anew ruling may be published that includesthe list in the original ruling and the ad-ditions, and supersedes all prior rulings inthe series.

Suspended is used in rare situationsto show that the previous published rul-ings will not be applied pending somefuture action such as the issuance of newor amended regulations, the outcome ofcases in litigation, or the outcome of aService study.

AbbreviationsThe following abbreviations in current useand formerly used will appear in materialpublished in the Bulletin.

A—Individual.Acq.—Acquiescence.B—Individual.BE—Beneficiary.BK—Bank.B.T.A.—Board of Tax Appeals.C—Individual.C.B.—Cumulative Bulletin.CFR—Code of Federal Regulations.CI—City.COOP—Cooperative.Ct.D.—Court Decision.CY—County.D—Decedent.DC—Dummy Corporation.DE—Donee.Del. Order—Delegation Order.DISC—Domestic International Sales Corporation.DR—Donor.E—Estate.EE—Employee.E.O.—Executive Order.

ER—Employer.ERISA—Employee Retirement Income Security Act.EX—Executor.F—Fiduciary.FC—Foreign Country.FICA—Federal Insurance Contributions Act.FISC—Foreign International Sales Company.FPH—Foreign Personal Holding Company.F.R.—Federal Register.FUTA—Federal Unemployment Tax Act.FX—Foreign corporation.G.C.M.—Chief Counsel’s Memorandum.GE—Grantee.GP—General Partner.GR—Grantor.IC—Insurance Company.I.R.B.—Internal Revenue Bulletin.LE—Lessee.LP—Limited Partner.LR—Lessor.M—Minor.Nonacq.—Nonacquiescence.O—Organization.P—Parent Corporation.PHC—Personal Holding Company.PO—Possession of the U.S.PR—Partner.

PRS—Partnership.PTE—Prohibited Transaction Exemption.Pub. L.—Public Law.REIT—Real Estate Investment Trust.Rev. Proc.—Revenue Procedure.Rev. Rul.—Revenue Ruling.S—Subsidiary.S.P.R.—Statement of Procedural Rules.Stat.—Statutes at Large.T—Target Corporation.T.C.—Tax Court.T.D. —Treasury Decision.TFE—Transferee.TFR—Transferor.T.I.R.—Technical Information Release.TP—Taxpayer.TR—Trust.TT—Trustee.U.S.C.—United States Code.X—Corporation.Y—Corporation.Z —Corporation.

2004-7 I.R.B. i February 17, 2004

Numerical Finding List1

Bulletins 2004–1 through 2004–7

Announcements:

2004-1, 2004-1 I.R.B. 254

2004-2, 2004-3 I.R.B. 322

2004-3, 2004-2 I.R.B. 294

2004-4, 2004-4 I.R.B. 357

2004-5, 2004-4 I.R.B. 362

2004-6, 2004-3 I.R.B. 322

2004-7, 2004-4 I.R.B. 365

2004-8, 2004-6 I.R.B. 441

2004-9, 2004-6 I.R.B. 441

2004-10, 2004-7 I.R.B. 501

Notices:

2004-1, 2004-2 I.R.B. 268

2004-2, 2004-2 I.R.B. 269

2004-3, 2004-5 I.R.B. 391

2004-4, 2004-2 I.R.B. 273

2004-5, 2004-7 I.R.B. 489

2004-6, 2004-3 I.R.B. 308

2004-7, 2004-3 I.R.B. 310

2004-8, 2004-4 I.R.B. 333

2004-9, 2004-4 I.R.B. 334

2004-10, 2004-6 I.R.B. 433

2004-11, 2004-6 I.R.B. 434

Proposed Regulations:

REG-116664-01, 2004-3 I.R.B. 319

REG-122379-02, 2004-5 I.R.B. 392

REG-139845-02, 2004-5 I.R.B. 397

REG-126459-03, 2004-6 I.R.B. 437

REG-156232-03, 2004-5 I.R.B. 399

Revenue Procedures:

2004-1, 2004-1 I.R.B. 1

2004-2, 2004-1 I.R.B. 83

2004-3, 2004-1 I.R.B. 114

2004-4, 2004-1 I.R.B. 125

2004-5, 2004-1 I.R.B. 167

2004-6, 2004-1 I.R.B. 197

2004-7, 2004-1 I.R.B. 237

2004-8, 2004-1 I.R.B. 240

2004-9, 2004-2 I.R.B. 275

2004-10, 2004-2 I.R.B. 288

2004-11, 2004-3 I.R.B. 311

2004-13, 2004-4 I.R.B. 335

2004-14, 2004-7 I.R.B. 489

2004-15, 2004-7 I.R.B. 490

Revenue Rulings:

2004-1, 2004-4 I.R.B. 325

2004-2, 2004-2 I.R.B. 265

2004-3, 2004-7 I.R.B. 486

Revenue Rulings— Continued:

2004-4, 2004-6 I.R.B. 414

2004-5, 2004-3 I.R.B. 295

2004-6, 2004-4 I.R.B. 328

2004-7, 2004-4 I.R.B. 327

2004-9, 2004-6 I.R.B. 428

2004-10, 2004-7 I.R.B. 484

2004-11, 2004-7 I.R.B. 480

2004-12, 2004-7 I.R.B. 478

2004-13, 2004-7 I.R.B. 485

Tax Conventions:

2004-3, 2004-7 I.R.B. 486

Treasury Decisions:

9099, 2004-2 I.R.B. 255

9100, 2004-3 I.R.B. 297

9101, 2004-5 I.R.B. 376

9102, 2004-5 I.R.B. 366

9103, 2004-3 I.R.B. 306

9104, 2004-6 I.R.B. 406

9105, 2004-6 I.R.B. 419

9106, 2004-5 I.R.B. 384

9107, 2004-7 I.R.B. 447

9108, 2004-6 I.R.B. 429

1 A cumulative list of all revenue rulings, revenue procedures, Treasury decisions, etc., published in Internal Revenue Bulletins 2003–27 through 2003–52 is in Internal Revenue Bulletin2003–52, dated December 29, 2003.

February 17, 2004 ii 2004-7 I.R.B.

Findings List of Current Actions onPreviously Published Items1

Bulletins 2004–1 through 2004–7

Proposed Regulations:

REG-115037-00

Corrected by

Ann. 2004-7, 2004-4 I.R.B. 365

REG-143321-02

Withdrawn by

REG-156232-03, 2004-5 I.R.B. 399

REG-146893-02

Corrected by

Ann. 2004-7, 2004-4 I.R.B. 365

Revenue Procedures:

94-41

Superseded by

Rev. Proc. 2004-15, 2004-7 I.R.B. 490

2000-38

Modified by

Rev. Proc. 2004-11, 2004-3 I.R.B. 311

2000-50

Modified by

Rev. Proc. 2004-11, 2004-3 I.R.B. 311

2002-9

Modified by

Rev. Proc. 2004-11, 2004-3 I.R.B. 311

2002-71

Superseded by

Rev. Proc. 2004-13, 2004-4 I.R.B. 335

2003-1

Superseded by

Rev. Proc. 2004-1, 2004-1 I.R.B. 1

2003-2

Superseded by

Rev. Proc. 2004-2, 2004-1 I.R.B. 83

2003-3

As amplified by Rev. Proc. 2003-14, and as

modified by Rev. Proc. 2003-48 superseded by

Rev. Proc. 2004-3, 2004-1 I.R.B. 114

2003-4

Superseded by

Rev. Proc. 2004-4, 2004-1 I.R.B. 125

2003-5

Superseded by

Rev. Proc. 2004-5, 2004-1 I.R.B. 167

2003-6

Superseded by

Rev. Proc. 2004-6, 2004-1 I.R.B. 197

Revenue Procedures— Continued:

2003-7

Superseded by

Rev. Proc. 2004-7, 2004-1 I.R.B. 237

2003-8

Superseded by

Rev. Proc. 2004-8, 2004-1 I.R.B. 240

2003-23

Modified and superseded by

Rev. Proc. 2004-14, 2004-7 I.R.B. 489

2004-1

Corrected by

Ann. 2004-8, 2004-6 I.R.B. 441

2004-4

Modified by

Rev. Proc. 2004-15, 2004-7 I.R.B. 490

2004-5

Modified by

Rev. Proc. 2004-15, 2004-7 I.R.B. 490

2004-6

Modified by

Rev. Proc. 2004-15, 2004-7 I.R.B. 490

1 A cumulative list of current actions on previously published items in Internal Revenue Bulletins 2003–27 through 2003–52 is in Internal Revenue Bulletin 2003–52, dated December 29,2003.

2004-7 I.R.B. iii February 17, 2004*U.S. G.P.O.: 2004—304–774/60122