[16924]
December 30, 2003
TO: TAX MEMBERS No. 68-03
ACCOUNTING/TREASURERS MEMBERS No. 63-03
ADVISER DISTRIBUTOR TAX ISSUES TASK FORCE No. 19-03
RE: FINAL REGULATIONS REGARDING CAPITALIZATION OF INTANGIBLE ASSETS
We are pleased to inform you that the Treasury Department and the Internal Revenue
Service have finalized regulations1 under Internal Revenue Code section 263 regarding the
deductibility or capitalization of amounts paid to acquire or create intangible assets. These
regulations reflect numerous Institute suggestions,2 discussed below, to regulations proposed in
2002.3 In general, these regulations are effective as of the date of filing with the Federal Register,
which is expected to occur by December 31, 2003.
The final regulations include several significant, broad changes that resolve technical
issues raised by the Institute. The final regulations eliminate the need to capitalize amounts
paid to “enhance” intangible assets acquired or created by the taxpayer and also eliminate the
broad potential ambiguity identified by the Institute in the proposed regulations. Moreover, the
preamble to the regulations states that if an amount paid to acquire or create an intangible asset
is not required to be capitalized under the final regulations or by another provision of the Code
or regulations thereunder, or in subsequent published guidance, the IRS will not argue that the
clear reflection of income requirement of Code section 446(b) and the regulations thereunder
necessitates capitalization. It should also be noted that the final regulations include a new
section of the regulations, Treas. Reg. 1.263(a)-5, which includes provisions (formerly included
within 1.263(a)-4) related to amounts paid to facilitate an acquisition of a trade or business, a
change in the capital structure of a business entity, and certain other transactions.
1 The final regulations are available at http://www.treas.gov/press/releases/reports/regs.pdf.
2 See, Institute Memoranda to Accounting/Treasurers Members No. 16-03, Adviser Distributor Tax Issues Task Force
No. 6-03, and Tax Members No. 18-03, dated March 19, 2003 [ No. 15761]; and to Accounting/Treasurers Members
No. 37-03, Adviser Distributor Tax Issues Task Force No. 18-03, and Tax Members No. 47-03, dated September 2, 2003
[No. 16480].
3 See, Institute Memorandum to Accounting/Treasurers Members No. 53-02 and Tax Members No. 53-02, dated
December 19, 2002 [No. 15475].
2
Expansion of Simplifying Assumption for Employee Costs to Include
Certain Director Fees and Contract Employee Expenses
The final regulations retain the simplifying assumptions generally permitting
deductions for employee compensation, overhead and de minimis costs. As requested by the
Institute, the simplifying convention for employee expenses has been expanded to include as an
employee expense a director’s annual compensation.4 The final regulations also expand
employee compensation treatment to payments to contract employees who perform
“secretarial, clerical, or similar administrative support services” (excluding services related to
the “preparation and distribution of proxy solicitations and other documents seeking
shareholder approval” for certain transactions). In addition, for corporations filing a
consolidated return, payments by one corporation to another for services performed by an
employee of the second corporation at a time when both corporations are members of the
affiliated group are treated as employee compensation.
Distributor Commissions
As urged by the Institute, the final regulations clarify that commissions paid by a
distributor to a broker pursuant to a distribution agreement covered by Rule 12b-1 are not
required to be capitalized. See Treas. Reg. 1.263(a)-(4)(l), Example 11. In this example, neither
the distributor’s cost of creating the distribution agreement nor the cost to the distributor of the
broker commissions for the sale of regulated investment company (“RIC”) shares must be
capitalized.
Fund Start-Up Expenses
Under the final regulations, a taxpayer must capitalize amounts incurred “in the process
of investigating or otherwise pursuing” the acquisition or creation of an intangible. An
agreement providing the taxpayer with the right to provide services is generally considered an
intangible asset under the regulations, which would require capitalization of costs attributable
to pursuing an advisory contract with a new fund (unless the costs were deductible under
another provision of the regulations, such as the simplifying convention for employee
compensation).
However, the final regulations state that a contract will not be considered to be an
agreement to provide services for purposes for the regulations if the other party has the right to
terminate the agreement within the period prescribed by Treas. Reg. 1.263(a)-4(f)(1) (the “12-
month rule”), and there is no economic compulsion against terminating the agreement within
that period. Moreover, the final regulations also provide that amounts paid to facilitate the
creation or renewal of an agreement with another that produces benefits for the taxpayer are
not required to be capitalized as amounts that facilitate the creation of a separate and distinct
intangible asset.
Thus, if an advisory contract allowed a fund to terminate the contract at will with 60
days notice, then it appears no start-up expenses would be required to be capitalized. This
4 Amounts paid to a director for attendance at a special meeting of the board of directors (or a committee thereof) is
not considered employee compensation for purposes of the simplifying convention, but may still be deductible
depending on the circumstances.
3
result is reflected in the distributor commission example, discussed above, where the
regulations note that distributor contracts are rarely terminated, but there is no economic
compulsion to continue the agreement, and therefore the fact that the distributor contract can be
terminated on 60 days notice means that the distributor need not capitalize the costs associated
with creating the distribution agreement.
Open-End RIC Stock Issuance and Redemption Costs
The final regulations, like the proposed regulations, expressly provide that open-end
RICs may deduct stock issuance costs (other than those related to the initial stock offering).
Also, as requested by the Institute, the final regulations confirm that stock redemption costs
paid by an open-end RIC are deductible.
Defense of Business Reputation -- “Fund Bailouts”
The final regulations retain an example from the proposed regulations with respect to
“fund bailout” payments made by an investment adviser in defense of its business reputation.
Example 6 of Treas. Reg. 1.263(a)-4(l) provides that when an investment adviser contributes
cash to a money market fund to prevent the fund’s net asset value from sinking below $1.00 per
share, the contribution may be deducted because it does not create an intangible asset. The
example states that the benefit derived by this payment to protect business reputation is not an
intangible asset for which capitalization is required.
Payments that Enhance Intangible Assets
As noted above, the final regulations do not require taxpayers to capitalize amounts
paid to “enhance” intangible assets that are acquired or created by the taxpayer. However,
taxpayers are required to capitalize amounts paid to enhance a separate and distinct intangible
asset and amounts paid to enhance a future benefit identified by the Service in published
guidance. However, in considering the potential impact of the “separate and distinct asset” test
on fund complexes, it should be noted that the final regulations contain a new provision
explicitly stating that “[a]mounts paid in performing services under an agreement are treated as
amounts that do not create a separate and distinct intangible asset . . . regardless of whether the
amounts results in the creation of an income stream under the agreement.” Treas. Reg.
1.263(a)-4(b)(3)(iii).
Payments with Respect to an Ongoing Business Relationship
As requested by the Institute, the final regulations clarify the treatment of amounts paid
in expectation of an ongoing business relationship. The final regulations provide that a
payment is not considered an amount paid to create, originate, enter into, renew or renegotiate
an agreement with another party “if the payment is made with the mere hope or expectation of
developing or maintaining a business relationship with that party and [the payment] is not
contingent on the origination, renewal or renegotiation of an agreement with that party.”
Change in Accounting Method
Special rules also are provided for those taxpayers seeking to change a method of
accounting to comply with the final regulations. For the taxpayer’s first taxable year ending on
4
or after the date that the final regulations are filed with the Federal Register, the taxpayer is
granted the consent of the Commissioner to change its accounting method under the
procedures that apply for an automatic consent to change accounting method. Treas. Reg.
1.446-1(e)(3)(ii).
With the exception of a change to a pooling method (as authorized in the final
regulations), a change in accounting method adjustment under section 481(a) will be
determined by taking into account only amounts paid or incurred in taxable years ending on or
after January 24, 2002 (the date of the publication of the Advance Notice of Proposed
Rulemaking5 related to capitalization guidance).
Catherine Barré David Orlin
Associate Counsel Assistant Counsel
5 See, Institute Memoranda to Tax Members No. 5-02 [No. 14400], dated January 25, 2002; and to Advisor Distributor
Tax Issues Task Force [No. 14401], dated January 25, 2002.