Trends & Developments - June 2011 - M&A, Restructuring and Other Transactions: Tax Treatment of Investigation and Pursuit Cost
Corporations and other taxpayers are required to capitalize (i.e., not currently deduct) amounts paid or accrued in the process of investigating or otherwise pursuing certain transactions. These costs (referred to as "facilitative" costs) usually involve legal, accounting, investment banking, appraisal, due diligence, engineering and similar types of services, but can include other payments. However, facilitative costs do not include the purchase price of tangible or intangible assets, the treatment of which is governed by other provisions of the Internal Revenue Code (the "Code").
THE TEN SUBJECT TRANSACTIONS
Treasury Regulations Section 1.263(a)-5 lists the following transactions (the "ten subject transactions") as to which facilitative costs are required to be capitalized:
- An acquisition of assets that constitute a trade or business (whether the taxpayer is the acquirer or the target).
- An acquisition by the taxpayer of an ownership interest in a business entity, if immediately after the acquisition, the taxpayer and the business entity are related (generally, over 50% ownership).
- An acquisition of an ownership interest in the taxpayer (other than an acquisition by the taxpayer of an ownership interest in itself).
- A restructuring, recapitalization, or reorganization of the capital structure of a business entity (including a tax-free reorganization, a distribution of stock in a tax-free spin-off, and a Chapter 11 bankruptcy proceeding as to the debtor's institution or administration costs).
- A transfer of assets to a corporation or a partnership (whether the taxpayer is the transferor or transferee).
- A formation or organization of a disregarded entity.
- An acquisition of capital.
- A stock issuance.
- A borrowing means any issuance of debt, including an issuance of debt in an acquisition of capital or in a recapitalization.
- The writing of an option.
If the transaction is not a tax-free reorganization, the acquirer (purchaser) must add its facilitative costs to the basis of the acquired assets or the acquired stock. Facilitative costs of the target (seller) are treated as a reduction of the target's amount realized on the disposition of its assets. In the case of an option writer, the capitalized facilitative costs reduce the total premium received. In Notice 2004-18 (2/19/2004), the Internal Revenue Service asked for comments relating to the proper tax treatment of amounts required to be capitalized as facilitative costs in a variety of transactions not covered by existing Treasury Regulations (e.g., tax-free transactions, corporate recapitalizations, stock issuances, etc.). Although the Notice stated an intention to develop rules which are clear and administrable, these rules have not yet been issued.
Fortunately, the potentially broad scope of the definition of facilitative costs and transactions that require their capitalization has significant limits. For example, amounts related to the integration of the business operations of a taxpayer with the business operations of another, whether paid before or after a transaction requiring capitalization of facilitative costs, are not considered facilitative. Amounts paid by an open-end regulated investment company to facilitate the issuance of its stock do not have to be capitalized, unless paid or incurred in connection with an initial stock offering. Similarly, registrar and transfer agent fees paid in connection with the transfer of a corporation's capital stock do not have to be capitalized, unless paid in connection with one of the ten subject transactions (e.g., the costs of distributing proxy statements requesting approval of a merger have to be capitalized). A de minimis rule exempts facilitative costs (other than commissions) that do not exceed $5,000 from the capitalization requirement. However, once that level is exceeded, none of the facilitative costs are considered de minimis.
The taxpayer's employee compensation and overhead expenses related to one of the ten subject transactions do not have to be capitalized. This includes guaranteed payments to a partner, annual compensation of a corporate director for attendance at regular meetings (as opposed to special meetings to consider a transaction), or payments to third parties for secretarial, clerical or similar administrative support services (other than services involving the preparation and distribution of proxy materials and other documents seeking shareholder approval of one of the ten subject transactions). This exception also applies to the costs of canceling unexercised employee stock options, even though this is done in the content of an acquisition transaction. However, an election is available to capitalize employee compensation, overhead and de minimis costs incurred in connection with investigating or otherwise pursuing one of the ten subject transactions.
Other transactions for which facilitative costs are not required to be capitalized involve the distribution or divestiture of stock or other assets required by law, regulatory mandate or court order.
EARLY COSTS FOR CERTAIN TRANSACTIONS
There are three types of acquisitive transactions for which costs (other than those treated as "inherently facilitative") may be currently deducted if incurred before certain action is taken. These transactions are:
- A taxable acquisition by the taxpayer of assets that constitute a trade or business.
- A taxable acquisition of an ownership interest in a business entity (whether the taxpayer is the acquirer or the target of the acquisition) if, immediately after the acquisition, the acquirer and the target are related within the meaning of Section 267(b) or Section 707(b) of the Code (generally, over 50% ownership).
- A tax-free reorganization described in Section 368(a)(1)(A) [merger or consolidation], (B) [stock for stock], or (C) [assets for stock], or a reorganization described in Section 368(a)(1)(D) [assets to another corporation which is controlled by the transferor or its shareholders] in which stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under Section 354 or 356 , whether the taxpayer is the acquirer or the target in the reorganization).
Amounts paid in the process of investigating or otherwise pursuing one of these acquisitive transactions are treated as facilitative only if related to activities performed on or after the earlier of:
- The date on which a letter of intent, exclusivity agreement, or similar written communication (other than a confidentiality agreement) is executed by representatives of the acquirer and the target; or
- The date on which the material terms of the transaction (as tentatively agreed by representatives of the acquirer and the target) are authorized or approved by the taxpayer's board of directors (or committee of the board of directors) or, in the case of a taxpayer that is not a corporation, the date on which the material terms of the transaction are authorized or approved by the appropriate governing officials of the taxpayer; or, in the case of a transaction that does not require authorization or approval of the taxpayer's board of directors (or appropriate governing officials in the case of a taxpayer that is not a corporation), the date on which the acquirer and the target execute a binding written contract reflecting the terms of the transaction.
Nevertheless, for the following activities, costs are deemed "inherently facilitative" and must be capitalized even if incurred before the above dates:
- Securing an appraisal, formal written evaluation, or fairness opinion related to the transaction;
- Structuring the transaction, including negotiating the structure of the transaction and obtaining tax advice;
- Preparing and reviewing the documents that effectuate the transaction (for example, a merger agreement or purchase agreement);
- Obtaining regulatory approval of the transaction, including preparation and reviewing regulatory filings;
- Obtaining shareholder approval of the transaction (for example, proxy costs, solicitation costs, and costs to promote the transaction to shareholders); or
- Conveying property between the parties to the transaction (for example, transfer taxes and title registration costs).
AREAS OF COMPLEXITY
Amounts paid in connection with one of the three types of acquisitive transactions that are contingent on the successful closing of the transaction are considered an amount paid to facilitate the transaction, except to the extent the taxpayer maintains sufficient documentation to establish that a portion of the success fee is allocable to activities that do not facilitate the transaction. Recognizing the difficulty that taxpayers have regarding the type and extent of the documentation required to establish what portion of a success-based fee is allocable to activities that do not facilitate an acquisitive transaction, the Internal Revenue Service recently announced a safe-harbor election — permitting a taxpayer to treat 70% of a success-based fee as an amount that does not facilitate the transaction — in Rev. Proc. 2011-29 (4/8/2011), effective for taxable years ending on or after April 8, 2011.
Another area of controversy relates to amounts paid to terminate (or facilitate the termination of) an agreement to enter into one of the ten subject transactions. Frequently, such termination costs are incurred so that the taxpayer can engage in another transaction. Are the termination costs for the first transaction considered facilitative of the subsequent transaction, so that capitalization is required? The Treasury Regulations take the position that the answer is "yes" only if the transactions are "mutually exclusive." For example, assume a corporation is the target of a hostile takeover attempt. Its investment banker finds a "white knight" acquirer and a letter of intent is signed with the white knight pursuant to which the target will merge into the white knight, and the target must pay the white knight $5 million if the merger does not occur. The target incurs significant facilitative costs in connection with the contemplated merger with the white knight. When the original suitor raises its offer, the target accepts and terminates the potential transaction with the white knight. Since the two transactions are mutually exclusive, the target must capitalize its facilitative expenses for the abandoned transaction with the white knight and the $5 million breakup fee.
Frequently, corporations engage in borrowing transactions for the purpose of entering into one of the other subject transactions. The costs incurred to facilitate the borrowing are capitalized with respect to the borrowing and not with respect to the other transaction. Generally, the costs relating to the borrowing may be written off (amortized) over the term of the loan.
Once facilitative costs are capitalized with respect to one of the ten types of subject transactions, they may become deductible at a later date. For example, facilitative costs related to an abandoned stock issuance or a potential loan transaction that is terminated may be deducted at the time of abandonment or termination, so long as they are not incurred to facilitate another transaction which is mutually exclusive. If a corporation investigates several possible acquisition candidates and incurs facilitative costs for each one, when it abandons one or more of the potential acquisitions the facilitative costs associated with the abandoned acquisition(s) can be deducted, provided the several transactions are not mutually exclusive.
CORRECTING AND AVOIDING ERRONEOUS TAX TREATMENT
Taxpayers who may not be following the requirements described above and who wish to change their method of accounting for facilitative costs to comply with the Treasury Regulations must secure the consent of the Internal Revenue Service. This can be accomplished under an automatic consent procedure. However, an adjustment is required under Section 481(a) of the Code that increases taxable income. This adjustment can be spread ratably over the year of change and the next three taxable years. It is computed by adding up all the facilitative costs that were expensed in years after 2003 and reducing that amount by the amount of such costs that would have been deducted (e.g., by depreciation or amortization) if the amounts had been capitalized. If a change in method is not initiated, a tax examination could result in a tax deficiency, interest and penalties.
In view of the required treatment of facilitative costs described above, taxpayers involved in one or more of the ten subject transactions should develop appropriate procedures to analyze and track all professional fees and other costs associated with these transactions. It is preferable to do this analysis during the course of a transaction (or shortly thereafter), rather than wait until the time for preparation of the tax returns for the year covered by the transaction. Failure to handle facilitative costs properly may give rise to a deficiency on an Internal Revenue Service examination. Moreover, improper treatment may cause a tax reporting requirement for an uncertain tax position or a financial statement recognition and disclosure pursuant to Accounting Standards Codification 740-10 (Accounting for Income Taxes).
Trends & Developments – June 2011
- M&A, Restructuring and Other Transactions: Tax Treatment of Investigation and Pursuit Cost
- Rewarding Key Employees of Closely Held Businesses — Phantom Equity and Section 409A
- Disclosure of Possible Losses
- Tax Consequences of Issuing Gift Cards & Store Credit
- Demystifying the Alternative Minimum Tax