Construction support payments to retailers need not be capitalized

Plain-English summary

Chief Counsel Advice considers whether construction support payments made by a product manufacturer to its retailers must be capitalized under the intangible-asset rules. The retailers had to maintain branded retail spaces and sell and service the manufacturer's products, but they did not have to buy a specified quantity. The IRS concluded that the payments did not create a capitalizable financial interest, contract right, or improvement to another person's real property. The payments therefore did not have to be capitalized under IRC § 1.263(a)-4.

Ruling snapshot

• Question: Must construction support payments made to retailers be capitalized under § 1.263(a)-4?
• Outcome: Approved.
• Key authorities: IRC §§ 161, 162, 263; Treas. Reg. § 1.263(a)-4.

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       memorandum
       Number: 201405014
       Release Date: 1/31/2014
       CC:ITA:B03 : MLLam                                    Third Party Communication: None
       POSTF-107569-13                                       Date of Communication: Not Applicable

UILC: 263.00-00

date: September 12, 2013

 to:   Joyce Marr
       Attorney
       CC:LB&I:CTM:LN
       (Large Business & International)

from: Sean Dwyer
Assistant to the Branch Chief, Branch 3
(Income Tax & Accounting)

subject: ------------------------------------------------------------------------------------------

       This Chief Counsel Advice responds to your request for assistance on whether
       construction support payments made by Taxpayer to its retailers are required to be
       capitalized by § 1.263-4 of the Income Tax Regulations. This advice may not be used
       or cited as precedent.


       LEGEND

       Taxpayer          =        ----------------------------------------

       Agreement =                ------------------------------------------------------------------------------------------
       ---------------------------------------------------------------------------------------------------------------------

       $x                =        --------------

       Facility          =        ------------------------------------------------

       Z                 =        ----------

       Slogan            =        -----------------

POSTF-107569-13 2

ISSUES

Whether construction support payments made by Taxpayer to its retailers are required
to be capitalized by § 1.263-4.

CONCLUSIONS

The construction support payments made by Taxpayer to its retailers are not required to
be capitalized by § 1.263(a)-4.

FACTS

Taxpayer produces Z products and distributes through a network of dedicated retailers.
Taxpayer has a standing offer for its retailers to enter an Agreement to maintain its retail
space as a Facility that conforms to Taxpayer’s design requirements. The Agreement
provides that Taxpayer will provide $x of construction support payments to retailers of Z
products, with a percentage paid upon groundbreaking or commencement of renovation
construction and a percentage paid upon commencement of operation of a Facility for Z
products. The agreement provides that repayment of all the construction support
payments to Taxpayer will be required immediately if within 15 years of commencing
operations as a Facility the retailer, seeks Taxpayer’s approval to no longer conform to
the requirements of a Facility or no longer sells and maintains a full line of Z products
and/or no longer provides servicing at the Facility.

The retailer is required to incorporate seven critical image elements, including:

(1) An elevated glass display several feet off the ground.

(2) An area with information and brochures.

(3) A display platform 1’ to 2’ off the ground.

(4) An area with a coffee machine and doughnuts.

(5) A greeter station with a computer.

(6) Key colors and materials.

(7) Key signage - Z signage and Slogan signage –Depending on the location of the
retailer, this could include signs in the building, on the building and/or on posts.

It is our understanding that the agreement does not obligate the retailer to purchase any
specific quantity of Z products, and does not confer with any right other than the right to
require the retailer to conform its premises to the Facility design.

LAW AND ANALYSIS

POSTF-107569-13 3

Section 162(a) of the Internal Revenue Code provides a deduction for all the ordinary
and necessary expenses paid or incurred during the taxable year in carrying on any
trade or business. Section 1.162-1(a) provides that deductible business expenses
include the ordinary and necessary expenditures directly connected with or pertaining to
the taxpayer's trade or business. Under § 161, if a cost is a capital expenditure, the
capitalization rules of § 263 take precedence over the deduction rules of § 162.
Commissioner v. Idaho Power Company, 418 U.S. 1 (1974). Therefore, a capital
expenditure cannot be deducted under § 162, regardless of whether the expenditure is
ordinary and necessary in carrying on a trade or business.

Section 263(a) provides generally that no deduction is allowed for any amount paid out
for new buildings or for permanent improvements or betterments made to increase the
value of any property or estate or any amount expended in restoring property or in
making good the exhaustion thereof for which an allowance is or has been made.

In Indopco, Inc. v. Commissioner, 503 U.S. 79, 86 (1991), the Court established the test
for capitalization as being whether an expense results in a significant future benefit.
Currently, the capitalization of intangibles is governed by §§ 1.263(a)-4 and 1.263(a)-5
which define the exclusive scope of the significant future benefit test, generally by
providing specific categories of intangible assets for which capitalization is required.

Section 1.263(a)-4 provides rules for applying § 263 to amounts paid to acquire or
create intangibles. Section 1.263(a)-4(b)(1) provides that except as otherwise provided
in § 1.263(a)-4, a taxpayer must capitalize an amount paid to: (i) acquire an intangible
(see § 1.263(a)-4(c)); (ii) create an intangible described in § 1.263(a)-4(d); (iii) create or
enhance a separate and distinct intangible asset within the meaning of § 1.263(a)-
4(b)(3); (iv) create or enhance a future benefit identified in the Federal Register or the
Internal Revenue Bulletin as an intangible for which capitalization is required; and (v)
facilitate (as defined in § 1.263(a)-4(e)(1)) the acquisition or creation of an intangible.

In general, advertising and marketing expenses are deductible because they do not fall
within a category required to be capitalized by § 1.263(a)-4. Even before the release of
§ 1.263(a)-4 in 2003, the future benefit from advertising was generally considered to be
too ephemeral to be a “significant future benefit”. See, Rev. Rul. 92-80; 1992-2 C.B. 57.

Although the Taxpayer’s construction support payments does not confer Taxpayer with
any interest in tangible property, it does create an intangible right to require the retailers
to conform to the Agreement’s Facility design concepts. We conclude that the
construction support payments do not create or enhance a separate and distinct
intangible asset within the meaning of § 1.263(a)-4(b)(3), because Taxpayer’s rights
have no value apart from the promotion of Taxpayer’s Z product line. Therefore we
examined whether the created intangible was required to be capitalized by § 1.263(a)-
4(d)(2) as creating a financial interest, § 1.263(a)-4(d)(6) as creating a contract right that
is required to capitalized, or § 1.263(a)-4(d)(8) as an improvement to real property
owned by another that can reasonably be expected to produce significant economic

POSTF-107569-13 4

benefits for the taxpayer. No other category of expenditure described in § 1.263(a)-4 is
relevant.

1.263(a)-4(d)(2) - Financial interests

Section 1.263(a)-4(d)(2)(i) provides that a taxpayer must capitalize amounts paid to
another party to create, originate, enter into, renew or renegotiate with that party any of
the financial interests enumerated in § 1.263(a)-4(d)(2)(i). Section 1.263(a)-4(d)(2)(i)
generally provides that a taxpayer must capitalize amounts paid to another party to
create, originate, enter into, renew or renegotiate with that party any of certain financial
interests. The construction support payments in this case do not involve any of the
items described in § 1.263(a)-4(d)(2)(i) except, possibly, forward contracts or options
described in § 1.263(a)-4(d)(2)(i)(C)(6) & (7).

An amount paid to another party is not paid to create, originate, enter into, renew or
renegotiate a financial interest with that party if the payment: (1) is made with the mere
hope or expectation of developing or maintaining a business relationship with that party
and (2) is not contingent on the origination, renewal, or renegotiation of a financial
interest with that party. Section 1.263(a)-4(d)(2)(ii).

In this case, the retailers are required to sell and maintain a full line of Z products and
provide servicing at the Facility. However, the retailers are not required to purchase any
specific amount of products from Taxpayer during the term of the agreement, and the
price of the product is not fixed at the time of the agreement. Taxpayer does not have
the right to provide any specific quantity of products to the retailers. Under these
circumstances, the agreement does not constitute a forward contract or option.
Accordingly, these amounts are not paid to create an intangible described in § 1.263(a)-
4(d)(2).

1.263(a)-4(d)(6) - Contract rights

Section 1.263(a)-4(d)(6) provides that a taxpayer must capitalize amounts paid to
another party to create, originate, enter into, renew or renegotiate with that party certain
enumerated agreements or covenants. These agreements include an agreement
providing the taxpayer: (1) the right to provide or to receive services or (2) the right to be
compensated for services regardless of whether the taxpayer provides such services.
Section 1.263(a)-4(d)(6)(i)(B). However, an agreement does not provide the taxpayer a
right to provide services if the agreement merely provides that the taxpayer will stand
ready to provide services if requested, but places no obligation on another person to
request or pay for the taxpayer's services. Section 1.263(a)-4(d)(6)(iv).

The agreement provides that the retailers shall sell a full line Z products and provide
servicing for Z products but does not obligate the retailer to purchase any specific
quantity of products or services from Taxpayer. Accordingly, these amounts are not
paid to create an intangible described in § 1.263(a)-4(d)(6).

POSTF-107569-13 5

1.263(a)-4(d)(8)- Real property

Section 1.263(a)-4(d)(8) provides that a taxpayer must capitalize amounts paid for real
property if the taxpayer transfers ownership of the real property to another person
(except to the extent the real property is sold for fair market value) and if the real
property can reasonably be expected to produce significant economic benefits to the
taxpayer after the transfer. A taxpayer also must capitalize amounts paid to produce or
improve real property owned by another (except to the extent the taxpayer is selling
services at fair market value to produce or improve the real property) if the real property
can reasonably be expected to produce significant economic benefits for the taxpayer.

Real property includes property that is affixed to real property and that will ordinarily
remain affixed for an indefinite period of time, such as roads, bridges, tunnels,
pavements, wharves and docks, breakwaters and sea walls, elevators, power
generation and transmission facilities, and pollution control facilities. Section 1.263(a)-
4(d)(8)(iii).

The seven critical image elements that are required to be incorporated do not appear to
fall under the definition of real property under § 1.263(a)-4(d)(8)(iii) as they would not
remain affixed for an indefinite period of time. Rather the seven critical image elements
appear to support Z’s marketing efforts and to standardize the appearance of Z’s
retailers. Some renovation may be required, and the retailers may be required to
capitalize some of these costs as purchases of or improvements to tangible property.
However, we do not believe that the Taxpayer’s payments to support these cosmetic
renovations constitute amounts paid to improve real property owned by another under §
1.263(a)-4(d)(8)(iii), since the improvements are not permanent structural changes, and
the benefit Taxpayer derives is akin to the benefit provided by advertising.

Therefore, the construction support payments made by Taxpayer to its retailers are not
required to be capitalized by § 1.263(a)-4.

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

Please call us at (202) 622-4950 if you have any further questions.