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Construction Support Payments to Retailers Don't Have to be Capitalized.
(Parker Tax Publishing February 2014)

Construction support payments made by a company to its retailers were not required to be capitalized because they did not create a financial interest, did not create a capitalizable contract right, and did not result in an improvement to real property owned by another that could reasonably be expected to produce significant economic benefits for the taxpayer. CCA 201405014.

A company produces certain products that it distributes through a network of dedicated retailers. The company has a standing offer for its retailers to enter an agreement to maintain retail space that conforms to the company's design requirements. The agreement provides that the company will provide a certain amount of construction support payments to retailers of the company's products, with a percentage paid upon groundbreaking or the beginning of the renovation construction and a percentage paid upon the beginning of operations of a facility for the company's products. The agreement provides that repayment of all the construction support payments to the company is required immediately if, within 15 years of beginning operations as a facility, the retailer seeks the company's approval to no longer conform to the requirements of a facility, or no longer sells and maintains a full line of the company's products, and/or no longer provides servicing at the facility.

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

(1) an elevated glass display several feet off the ground;

(2) an area with information and brochures;

(3) a display platform one foot to two feet off the ground;

(4) an area with a coffee machine and doughnuts;

(5) a greeter station with a computer;

(6) key colors and materials; and

(7) key signage - product signage and slogan signage.

Depending on the location of the retailer, the signage could include signs in the building, on the building and/or on posts. The agreement does not obligate the retailer to purchase any specific quantity of the company's products, and does not confer with any right other than the right to require the retailer to conform its premises to the facility design.

In Indopco, Inc. v. Comm'r, 503 U.S. 79, 86 (1991), the Supreme Court established the test for capitalization as being whether an expense results in a significant future benefit. The capitalization of intangibles is governed by Reg. Sec. 1.263(a)-4 and Reg. Sec. 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. Reg. Sec. 1.263(a)-4 provides rules for applying the capitalization rules to amounts paid to acquire or create intangibles. Reg. Sec. 1.263(a)-4(b)(1) provides that except as otherwise provided, a taxpayer must capitalize an amount paid to:

(1) acquire an intangible;

(2) create an intangible described in Reg. Sec. 1.263(a)-4(d);

(3) create or enhance a separate and distinct intangible asset within the meaning of Reg. Sec. 1.263(a)-4(b)(3);

(4) create or enhance a future benefit identified in IRS guidance as an intangible for which capitalization is required; and

(5) facilitate 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. Generally, the future benefit from advertising is considered to be too ephemeral to be a significant future benefit.

The Office of Chief Counsel concluded that the construction support payments did not create or enhance a separate and distinct intangible asset because the company's rights have no value apart from the promotion of the company's product line. The Chief Counsel's Office then examined whether the created intangible was required to be capitalized because it created a financial interest, created a contract right that was required to capitalized, or was an improvement to real property owned by another that could reasonably be expected to produce significant economic benefits for the taxpayer. No other category of expenditure was relevant, the Chief Counsel's Office noted.

The Chief Counsel's Office noted that while the retailers are required to sell and maintain a full line of the company's products and provide servicing at the facility, the retailers are not required to purchase any specific amount of products from the company during the term of the agreement, the price of the product is not fixed at the time of the agreement, and the company does not have the right to provide any specific quantity of products to the retailers. Under these circumstances, the Chief Counsel's Office found that the agreement did not constitute a forward contract or option and, thus, the amounts were not paid to create a capitalizable financial interest under Reg. Sec. 1.263(a)-4(d)(2).

Further, the Chief Counsel's Office stated, because the agreement provides that the retailers must sell a full line of the company's products and provide servicing for the products but does not obligate the retailer to purchase any specific quantity of products or services from the company, these amounts are not paid to create a contract right under Reg. Sec. 1.263(a)-4(d)(6).

Finally, the Chief Counsel's Office noted that, for purposes of capitalizing real property, such 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. The seven critical image elements that are required to be incorporated in the facility design, the Chief Counsel's Office stated, did not appear to fall under the definition of real property under Reg. Sec. 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 appeared to the Chief Counsel's Office to support the company's marketing efforts and to standardize the appearance of the company's retailers. While 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, the Chief Counsel's Office did not believe that the taxpayer's payments to support these cosmetic renovations constituted amounts paid to improve real property owned by another under Reg. Sec. 1.263(a)-4(d)(8)(iii), since the improvements were not permanent structural changes, and the benefit the company derived was akin to the benefit provided by advertising. Therefore, the construction support payments made by the company to its retailers were not required to be capitalized.

For a discussion of the capitalization of intangibles, see Parker Tax, ΒΆ99,580. (Staff Contributor Parker Tax Publishing)

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