• Transaction Cost Allocation Guidance Proliferates
  • June 15, 2005 | Author: Annette M. Ahlers
  • Law Firm: Pepper Hamilton LLP - Washington Office
  • Since the issuance of the capitalization regulations found in Treas. Reg. Section 1.263(a)-5 in December 2003, the IRS has released several rulings and one LMSB Industry Directive that affect the deductibility of certain transaction costs for years before December 2003. Generally, the capitalization regulations provide a framework for determining which costs incurred in a corporate transaction may be deductible (if properly documented) and which costs must be capitalized.

    This article provides a brief overview of TAM 200503026 (October 26, 2004), TAM 200512021 (December 29, 2004), TAM 200521032 (February 11, 2005) and LMSB Directive titled "Examination of Transaction Costs in the Acquisition of Businesses" issued on May 20, 2005.1 None of these "authorities" can be relied upon as authority for the conclusions reached, but they do indicate an approach taken by the IRS on these facts patterns.

    TAM 200503026 -- Stock Issuance Costs

    In TAM 200503026, the taxpayer attempted to deduct under Section 165 previously capitalized stock issuance costs when the target corporation that issued the stock ultimately merged into the taxpayer in a Section 368(a)(1)(A) merger. The IRS found that, because the stock issuance costs were taken into account against the proceeds of the stock offering, nothing was capitalized on the target corporation's tax books, so no asset was available to create a deduction when the target corporation was merged out of existence. In relaying the relevant facts of the transaction, the IRS noted that the target corporation had reflected the stock issuance costs in the equity section of the target corporation's financial statements. In addition, the IRS pointed out that none of the costs were deducted on the tax return of the target corporation at the time of the stock issuance transaction.

    Pepper Perspective -- Documentation on Non-Facilitative Activities May be the Key

    The result of the TAM is not surprising, given that the most common view of the state of the law on the treatment of stock issuance costs requires that these costs be treated as an offset to the proceeds received, and are neither deductible or capitalizable. The facts pointed out by the IRS in reaching its conclusions may, however, provide some insight for similarly situated taxpayers who might be able to document that some portion of their costs fall into a deductible category.

    For example, if the target corporation in the TAM had attempted to document that certain of its costs incurred in the stock issuance transaction were properly allocable to services other than the stock issuance, including costs associated with employee plan revisions, abandoned transactions that were considered but not pursued, certain compliance costs associated with being a public company, etc., would the effect of the inability to capitalize (and later write off) stock issuance costs been mitigated?

    In addition, because many companies must take into account an equity issuance for financial statement purposes long before they prepare their tax return, will the IRS view an allocation of the stock issuance costs to equity for financial statement purposes as perhaps precluding a deduction of a portion of those costs when the taxpayer ultimately files their tax return many months later?

    We believe that both of these scenarios highlight the importance of detailed documentation at the time transaction costs are being incurred to preserve all appropriate tax positions that would allow for an allocation of some portion of the fees incurred in and around a corporate transaction to potentially deducible activities. Absent such detailed documentation prior to either financial statement treatment and/or federal income tax treatment, a taxpayer may be left with few arguments that allow for a deduction.

    TAMs 200512021 and 200521032 -- Termination Fees

    These two TAMS address whether or not a break-up fee paid to a losing suitor in an acquisition transaction can be properly deductible under Section 162 as an ordinary or necessary business expense, or can be deducted under 165 as an abandonment loss. Both TAMS conclude that the termination fees are capital expenditures that must be capitalized under Section 263.

    In almost identical law and analysis sections in the TAMS, the IRS applied an "origin of the claim" approach and determined that each of the subject termination fees allowed each of the target companies to enter into transactions that produced long-term future benefits for the businesses in these target companies. The IRS distinguished authorities that allowed a deduction for companies paying fees to terminate unfavorable contracts, and indicated that in present transactions the termination fees were not similar to the unfavorable contract cases, but instead allowed each corporation to enter into beneficial acquisition transactions creating long term benefits. The IRS also includes an endnote that refers to the rule in Treas. Reg. Section 1.263(a)-5(c)(8) which treats termination fees paid to a party in a proposed transaction as facilitative to a completed transaction if the two transactions are mutually exclusive.

    Pepper Perspective -- Termination Fees Still May be Deducible if Two Transactions Not "Mutually Exclusive" Under the Capitalization Regulations

    These two TAMs utilize an "origin of the claim" approach to find that termination fees paid to one potential suitor to be acquired by another suitor create a long-term future benefit for the acquired company by facilitating the ultimately consummated transaction, and so must be capitalized under Section 263. There is room for a deduction of termination fees, however, in situations where the taxpayer can show no long-term future benefit,2 or if the costs are incurred after application of the capitalization regulations (post-December 2003) and the taxpayer can show that the termination fee was paid in situations where the two subject transactions were not mutually exclusive.

    LMSB Directive for Pre-December 2003 Transaction Costs

    This directive states that it is intended to reduce audit issues raised by the deduction of costs incurred in connection with certain merger and acquisition transactions. The directive explains that LMSB examinations of transaction costs for tax years ending on or before December 31, 2003 (the date the capitalization regulations found in Treas. Reg. 1.263(a)-5 became effective) have generally resulted in the capitalization of 50-65 percent of the applicable transaction costs. The directive is somewhat limited, however, in that it is not intended to apply to the deduction of costs in non-merger or acquisition corporate transactions, including, for example, costs incurred in a stock issuance, stock redemption or stock distribution, etc. In addition, the directive mentions the recordkeeping requirements of the capitalization regulations found in Treas. Reg. Section 1.263(a)-5(e) but does not clarify any of the regulations' numerous questions concerning what will be acceptable documentation of fees paid to service providers that do not keep detailed time records, i.e., investment bankers.

    Pepper Perspective -- No Safe Harbor on Exam

    Although it is not a "safe harbor" for affected taxpayers, it may have the effect of reducing the controversies surrounding these issues in the exam process when a taxpayer deducts certain costs incurred in a merger or acquisition transaction. Note, however, that because documentation standards do not appear to be effected by this directive, the IRS may still feel free to challenge a taxpayer's allocation of transaction costs based on several theories, including; whether or not the taxpayer's documentation methodology and detail is sufficient. Also, under these limited exceptions to challenge on audit, the IRS also could choose to review any type of transaction that is not considered a merger or acquisition under these rules or because the taxpayer capitalized less than 50 percent of the relevant transaction costs. Therefore, while the directive may alleviate certain audit risks, it by no means appears to create any comfort on many common corporate transactions and deductibility positions. As a result, taxpayers are still advised to be prepared to provide detailed documentation substantiating their deduction positions with respect to corporate transaction costs.


    1 See, http://www.irs.gov/businesses/corporations/article/0,,id=139111,00.html.

    2 While the "no future benefit" argument is available, it has not succeeded in any but the most narrow cases, i.e., when the government or other regulatory body requires divesture of a business unit.

    See, El Paso Co. v. U.S., 694 F.2d 703 (Cl. Ct. 1982). Most courts and the IRS follow the view that any corporate acquisition transaction that is a friendly (as opposed to a hostile takeover) acquisition provides long term future benefits to the parties to the transaction.

    See, in general, A.E. Staley Mfg. v. Comm'r, 119 F.3d 482 (7th Cir. 1997) (holding that the deductibility of costs incurred to defend against a hostile offer, which Target ultimately accepted, is based on a facts and circumstances inquiry into whether such costs are incurred in the defense of a business or as costs facilitating a transaction); In re Federated Dep't Stores, Inc., 171 B.R. 603 (S.D. Ohio 1994), aff'g 135 B.R. 950 (Bankr. S.D. Ohio 1992).