Despite persistent delays in the issuance of a number of tax accounting guidance projects over the last two years, recent developments suggest that several high-profile projects are nearing completion and should be issued soon. These include the proposed tangibles regulations, guidance regarding the treatment of sales-based royalties, and guidance on the treatment of "success-based fees" incurred in connection with corporate acquisitions.

Proposed Tangibles Regulations

Treasury has indicated recently that the target date for issuing the long-awaited "tangibles regulations" is the end of 2010, but that this date may slip into early 2011. Despite similar predictions having been made several times since the regulations were re-proposed in March 2008, Treasury seems confident in this prediction. Deputy Assistant Treasury Secretary (Tax Policy) Emily McMahon recently identified this project as being on the short-list of high-priority items likely to be published soon.

Indications are that Treasury and the IRS are likely to make substantial changes to the regulations re-proposed in March 2008. The definition of "unit of property" -- particularly in the context of buildings -- may be among the changes. Treasury and IRS also have been working on two industry issue resolutions (IIRs) defining the "unit of property" in the telecommunications and electric utility industries. Those projects are related to the proposed regulations and the same IRS and Treasury personnel are working on each of them, but the projects are being developed on independent timetables (meaning the proposed regulations will not delay the IIRs and vice versa).

Treasury and IRS have given no indication as to other specific issues or standards being reconsidered, but given the effort that has gone into reexamining the 2008 proposed regulations, many observers expect the changes to be more than "tweaks." Treasury and IRS officials have stated, however, that to the extent the new regulations differ substantially from those proposed in 2008, they will be issued in proposed and perhaps temporary (meaning they would be effective immediately) form. As such, it is expected that the package of regulations to be issued in early 2011 will be a combination of final, temporary, and proposed regulations.

Sales-Based Royalties

Treasury and IRS also have been working on guidance addressing the application of the uniform capitalization rules of section 263A to so-called sales-based royalties. Although the fact patterns involving such royalties vary widely, a typical scenario involves a manufacturer paying a royalty to a third-party for the right to use a popular brand name owned by the third-party. Use of the brand name is intended to increase sales of the taxpayer's goods. The owner of the brand name receives a royalty computed as a percentage of the sales price of each unit bearing that brand name sold by the taxpayer to a third party. In Robinson Knife Manuf. Co. v. Commissioner, the Tax Court concluded on similar facts that the royalties directly benefited or were incurred by reason of the taxpayer's production activities, and as such were required to be capitalized as production costs. The Second Circuit disagreed, holding that a royalty is deductible if it arises only upon the sale of an item and its amount is determined by reference to the revenue generated by that sale. Robinson Knife was discussed in a prior Miller & Chevalier Tax Accounting Alert.

Published guidance addressing the application of section 263A to sales-based royalties is believed to be imminent. Given public statements by Treasury and IRS officials regarding their view of the Second Circuit's decision in Robinson Knife, the guidance is expected to require treating the royalties as capitalized production costs. We believe it is likely, however, that the guidance will allow the capitalized royalties to be recovered immediately through cost of goods sold, depending upon the taxpayer's specific facts and on the nature of its method of accounting under section 263A.

Success-Based Fees

Finally, recent public statements by Treasury and IRS officials indicate that the government is completing work on a long-awaited project addressing the deductibility of costs incurred in connection with corporate acquisitions. Under section 1.263(a)-5 of the regulations, transaction costs that "facilitate" certain corporate transactions must be capitalized. A cost facilitates such a transaction if it is paid in the process of investigating or otherwise pursuing the transaction. The regulations provide a special rule for certain acquisitions, however. Under this special rule, costs incurred prior to the date on which the taxpayer determines whether to undertake an acquisition and which target to acquire are deductible, unless those costs are "inherently facilitative." Inherently facilitative costs (such as costs for preparing the "deal documents," appraisal costs, and obtaining regulatory or shareholder approval) always must be capitalized. The regulations create a presumption that "success-based" fees (such as certain fees paid to investment bankers) are facilitative costs that must be capitalized, unless the taxpayer maintains sufficient contemporaneous documentation to establish that a portion of the fee is allocable to activities that do not facilitate the transaction.

The nature and extent of the documentation that satisfies this requirement has been a source of controversy between taxpayers and exam teams since the regulations were issued in 2003. Treasury and the IRS are expected to release guidance clarifying this inherently factual inquiry in the near future (perhaps by the end of the calendar year). Recent comments by Treasury and IRS officials suggest that the guidance is unlikely to take the form of a "safe harbor" or bright-line rules. Instead, it is likely to provide broad standards and examples as to the types of documentation contemplated by this requirement and the extent of documentation that is likely to be sufficient to support a current deduction.

The higher priority now being placed on the success-based fees project by Treasury and IRS likely has delayed the publication of other guidance needed under section 1.263(a)-5. While those regulations provide the standards for determining whether transaction costs must be capitalized, they provide limited guidance on how the taxpayer is to recover those capitalized costs. When finalizing the capitalization regulations in 2003, Treasury and the IRS announced that they would issue follow-up regulations addressing the amortization of these capitalized costs, but to date have not done so. Recent comments suggest that the success-based fees guidance has leap-frogged the amortization project, likely delaying that project until at least 2011, if not later.

It is never too soon for taxpayers to begin planning for these anticipated changes in tax accounting. Miller & Chevalier's Tax Accounting group is one of the nation’s best, and includes former IRS National Office tax accounting officials (including a former Associate Chief Counsel (Income Tax & Accounting)); the author of Federal Tax Accounting, the nation's leading treatise in the area; and numerous others experienced in handling tax accounting matters.

For more information, please contact:

Stephen F. Gertzman, sgertzman@milchev.com, 202-626-6080

Patricia Sweeney, psweeney@milchev.com, 202-626-5926

James Atkinson*

Dwight Mersereau*

*Former Miller & Chevalier attorney

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