Tax Treatment of Transaction Costs

Jon Zefi

TEI Meeting

September 25, 2015

• What are transaction costs?

• What tax issues affect transaction costs?

• What are the most important rules?

• Who gets the tax benefits?

• When are tax benefits allocated?

Agenda

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• Costs incurred in connection with an M&A transaction

– Fees paid to outside vendors

• E.g., investment bankers, lawyers, accountants, consultants

– Costs associated with investigation of the value of the transaction

– Other costs necessary to the deal but not part of the price paid for the deal

What are Transaction Costs?

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Main Tax Issues

• Main Issue: Deduct or Capitalize?

• INDOPCO v. Commissioner (1992)

– Leading case in this area

– Because the transaction produced significant benefits extending beyond tax year in question, taxpayer could not deduct investment banking, legal, and other fees incurred in a friendly takeover as ordinary and necessary business expenses

• Generally, transaction costs that “facilitate” a transaction must be capitalized whereas those that are not “facilitative” may be currently deducted

• Tax treatment for most transaction costs is determined under Treas. Reg. 1.263(a)-5

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• Amounts paid to “facilitate” are those paid in “investigating or otherwise pursuing” the transaction. Facilitation costs must be capitalized, not currently deducted. – Includes amounts paid to determine value or price of transaction

– Excludes amounts paid to another party in exchange for tangible or intangible property

– Excludes ordinary employment compensation

• Payments to directors for attendance at regular board meetings are not facilitative; payments for attendance at special meetings are facilitative

• Compensation, for these purposes, includes guaranteed payments to partners

– Excludes de minimis costs

• Costs up to $5,000 , but if aggregate costs exceed $5,000, none may be treated as de minimis

– Excludes overhead costs

– Does not affect the amortization election for start-up expenditures under IRC 195

General Rule: “Facilitation”

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• A success-based fee is the portion of a fee that becomes payable only on the successful completion of a transaction

• It must be capitalized unless the taxpayer has maintained sufficient documentation to establish that a portion of the fee is allocable to activities that do not facilitate the transaction

• Rev. Proc. 2011-29 provides a safe harbor election for allocating success-based fees:

– Provides for 70% of fee to be currently deducted and 30% capitalized

– Requires a statement attached to original return for year in which fee is paid or incurred

Special Rule: Success-Based Fees Rule

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• When a deal is contemplated, and costs incurred, but the deal fails, there is no future benefit as contemplated by INDOPCO

• Generally, costs incurred in connection with a merger or acquisition that fails may be currently deducted, even if the taxpayer later enters into another deal

• Exception: Termination Fees

– A termination fee is an amount paid to terminate an agreement to enter into a transaction

– Termination fees paid to exit one transaction so that the payor may enter into a second transaction constitute amounts paid to facilitate a second transaction if the transactions are mutually exclusive and must be capitalized

Special Rule: Failed or Cancelled Deals

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• General rules apply to a wide variety of transactions

• Special rules for “covered transactions” under Treas. Reg. 1.263(a)-5(e) designed to increase certainty – Taxpayer’s taxable acquisition of assets constituting a trade or business

(where taxpayer is acquirer)

– Taxable acquisition of ownership interest in a business entity if, immediately after the acquisition, Acquirer and Target are related (regardless of whether the taxpayer is the acquirer or target)

– Most tax-free reorganizations

– Bright Line Rule

• “Letter of Intent Date”

• “Board Approval Date”

– Inherently Facilitative Amounts

• Described in Treas. Reg. 1.263(a)-5(e)(2)

Special Rule: Covered Transactions

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• Pre-acquisition transaction costs, which a target corporation had previously capitalized, are not deductible as a result of the target’s subsequent transfer of property to the acquiring parent and subsequent dissolution of the target

• The costs must continue to be capitalized by the parent

Previously Capitalized Transaction Costs

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• Where multiple parties to a transaction incur transaction costs, to whom should the deductions and capitalized expenditures be allocated?

– The IRS has ruled that taxpayers may allocate costs incurred by one party to a transaction to another party to the transaction, provided that the costs were incurred for the other party’s benefit

• Example

– Acquirer creates Holdco; Holdco creates Merger Sub; Merger Sub merges with Target; Target survives

– Throughout the process, all entities paid for transaction costs which were incurred for Target’s benefit

– Service ruled that parties could allocate deductions and capitalized expenses to Target

Cost Allocation – Who Gets the Benefit?

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• Generally, when a corporation enters or leaves a consolidated group, its tax year closes at the end of the day on which the change occurs, and a new tax year starts on the day following the change

• Exception: The “Next-Day Rule” provides that where a transaction occurs on the same day as a status change :

– If the transaction is “properly allocable” to the portion of the day after the change of status, then it must be treated as occurring on the next day after the change of status

– A determination as to whether the transaction is “properly allocable” to the portion of the day before or after the change in status will be respected if it is reasonable and consistently applied by all affected persons

– Has been treated by taxpayers as elective, and taxpayers have allocated closing-day transaction costs between Target and Acquirer’s tax periods so as to achieve most advantageous tax treatment

Cost Allocation – The Next Day Rule (Current)

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• IRS and Treasury view: Current Next Day Rule leads to uncertainty and inappropriate electivity, perceived as abuse

• Prop. Treas. Reg. 1.1502-76 would tighten the Next Day Rule and reduce availability of elective allocation of closing-day costs – Costs for “extraordinary items” incurred simultaneously with the event

causing the change in consolidated group status (i.e., closing) must be allocated to the day of the change

– Costs incurred for “extraordinary items” incurred on the day of closing (but after closing) must be allocated to the next day after closing

– “Extraordinary items” include many common transaction costs, e.g., payments in cancellation of stock options, success-based fees, and compensation-related deductions in connection with the transaction

Cost Allocation – The Next Day Rule (Proposed)

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This publication is intended to provide general information to our clients and friends, It does not

constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the

subject matter.

Any tax advice contained in this memorandum (including any attachments) is not intended for and

cannot be used, for the purpose of (i) avoiding penalties imposed by the Internal Revenue Code or (ii)

promoting, marketing, or recommending any transaction or matter addressed herein.