On January 1, 2010, the IRS released a ruling (PLR 2009-53-014)1 that provides deeper insight into the provisions of Treas. Reg. § 1.263(a)-5 (the "transaction costs regulations"). In the ruling, the IRS held that a company could take into account merger transaction costs that were arranged for and incurred by one or more companies in an acquisition transaction when (i) the company can demonstrate that the services were directly rendered to the company, and/or on behalf of the company, and (ii) the fees associated with such services were paid for by the company, and/or reimbursed by the company, among other rulings.
In the transaction at issue, the target company (the Taxpayer) was the surviving company in an acquisitive merger, which was accomplished by the use of an acquisition subsidiary (Merger Sub), which merged into Taxpayer and out of existence. The Taxpayer was a public corporation that was to be taken private in a acquisition funded by an Acquiring Group consisting of private equity financial buyers and related-industry strategic buyers.
Service Fees at Issue
Prior to and during the course of the transaction costs were incurred by both the Acquiring Group and the Taxpayer. At issue in the ruling was whether the Taxpayer could deduct certain costs incurred during the transaction, and the standards it should use in determining the character of those costs.
The Acquiring Group arranged for (and in certain instances incurred) a number of transaction-related costs prior to completion of the transaction. The Acquiring Group arranged for various service providers to plan, model, investigate, pursue, and finally complete the Transaction. In many cases, the services arranged for by the Acquiring Group were meant to benefit the Taxpayer, as it was to survive the merger. Specifically, these advisors provided advice regarding corporate governance and other advice directly to the Taxpayer’s Board of Directors.
Additionally, the Taxpayer engaged other financial advisors to provide advice directly to the Taxpayer and its Board of Directors regarding different strategic transaction alternatives, prior to deciding to move forward with the Acquiring Group on a transaction. After deciding to proceed with the Transaction, Taxpayer engaged financial advisors, legal advisors, accounting service providers, and other service providers to advise on securing debt financing arrangements related to the Transaction and to evaluate the Transaction. In addition, members of the Acquiring Group itself were engaged by the Taxpayer to provided Transaction-related services.
Regardless of whether the Taxpayer or the Acquiring Group engaged the service providers, the Taxpayer paid for any fees for these services if they were directly aimed at benefitting the Taxpayer’s business going forward. The Taxpayer requested two principal rulings that were intended to bless both the Taxpayer’s ability to deduct the fees it paid for providers it did not engage, and the Taxpayer’s method of determining the tax treatment of the fees.
Deductibility by the Taxpayer
In most circumstances, one corporation’s payment of another corporation’s expenses does not give rise to a trade or business tax deduction for the payor corporation. However, there is a line of Tax Court cases that endorse the deduction of such costs when they are paid by the party that "directly and proximately benefits" from the services, even if the payor was not the party that engaged the service provider.2
The IRS ruled that on the authority of that line of cases, a deduction may "be taken into account by a taxpayer where the taxpayer properly incurs the liability associated with the costs" and that in order to make that determination, the particular facts of the transaction must be evaluated—including the parties object in incurring the cost, the nature of the transaction, the relationship of the parties, and the anticipated benefit to be derived from incurring the cost.
The IRS ruled that the Taxpayer could properly deduct transaction-related service fees arranged for by another party to the transaction, if based on the facts and the factors listed, the Taxpayer (i) could demonstrate that the services were directly rendered to the Taxpayer, and/or on behalf of the Taxpayer, and (ii) the fees associated with such services were paid for by the Taxpayer, and/or reimbursed by the Taxpayer.
Tax Treatment of the Fees
Under the transaction costs regulations, costs that facilitate the acquisition of a business generally must be capitalized, and other costs are typically deductible. The regulations specifically describe some activities as inherently facilitative, and thus require that their associated costs be capitalized.3 However, outside of those delineated activities, the regulations provide that an amount is paid to facilitate a transaction if the amount is paid in the process of investigating or otherwise pursuing the transaction, if it relates to activities performed on or after the earlier of the date a letter of intent or similar communication is executed or the date on which the material terms of the transaction are authorized or approved by the taxpayer’s board of directors.4 Whether an amount is paid in the process of investigation or otherwise pursuing the transaction is determined based on all of the facts and circumstances.
This factual determination is difficult to make when a taxpayer makes payments of success-based fees to a service provider, whose activities are partially facilitative and partially not. The Treasury Department provided some guidance about what factual documentation may be used by a taxpayer to support its position that certain fees are not facilitative in Treas. Reg. § 1.263(a)-5(f). In general, the documentation must consist of supporting records that identify the activities performed by the service provider, the fee allocable to those activities, and the date of performance. Additionally, this documentation must be completed on or before the due date for the taxpayer’s timely filed return. In this case, the Taxpayer requested a ruling on whether the types of evidence it was using to allocate success-based fees were sufficient, and specifically if Treas. Reg. § 1.263(a)-5(f) could be satisfied to successfully support a deduction of a portion of a success-based fee, even if a taxpayer could not provide detailed time records.
The IRS ruled that the regulation "does not require time records" in order to factually demonstrate the elements necessary to determine which service provider fees the Taxpayer could take into account. Rather, the IRS ruled that a Taxpayer "should evaluate all available evidence." In the ruling, the IRS endorsed the Taxpayer’s documentation used to make its determinations, such as service provider attestation regarding the scope and timing of services (e.g., interview memoranda and fee allocation letters), service provider engagement letters, board of director meeting minutes, documents developed by the providers and presented to the board of directors, management agreements, flow of funds memos, wire transfer and other bank records, transaction documents, and the Taxpayer’s internal accounting information. The IRS cited authority that such documentation is appropriate to apportion costs, "even if the apportionment derived … is ‘less scientific’."5
Other Rulings
In addition to the two principal rulings, the IRS also issued two other rulings to the Taxpayer. First, the IRS specifically approved that the Taxpayer could take trade or business expense deductions for costs incurred in a business expansion context that relate to (i) expanding an active trade or business, and (ii) for investigating a transaction prior to making a decision to proceed with the transaction. In doing so, the IRS endorsed several cases that support the deductibility of these costs.6 Second, the IRS ruled that costs paid by the Taxpayer in connection with financing the Transaction are eligible for amortization over the term of the debt per Treas. Reg. § 1.446-5, even though this was a going private transaction.
Pepper Perspective
At the end of the day, this is a single ruling that cannot be cited for precedent, and it is based largely on the particular Taxpayer’s facts. However, it is an excellent indicator of the thinking of the IRS and how it plans to interpret law and regulations in the future, and of opportunities to serve our clients in the future.
Moreover, this is the second time that the IRS has ruled in the regarding the deductibility of transaction costs in two years,7 which indicates that the IRS is becoming more comfortable in ruling on the transaction cost allocation regulations. The Internal Revenue Code and attendant regulations regarding the deductibility of transaction costs contain a number of ambiguities, which in recent years have resulted in a substantial increase in examinations of taxpayers’ returns. Therefore, this ruling represents a very positive development for all taxpayers, because it means a taxpayer can obtain protection from such examinations with respect to the costs evaluated.
Endnotes
1 http://www.irs.gov/pub/irs-wd/0953014.pdf.
2 See Square D v. Comm’r, 121 T.C. 168 (2003); see also Dinardo v. Comm’r, 22 T.C. 430 (1954); Fishing Tackle Products Co. v. Comm’r, 27 T.C. 638 (1957).
3 Treas. Reg. § 1.263(a)-5(e)(2).
4 Treas. Reg. §§ 1.263(a)-5(b) & (e).
5 See Putnam-Greene Financial Corp. v. United States, 308 F.Supp. 2d 1374 (Mid. D. Ga. 2004).
6 Briarcliff Candy Corp v. Comm’r, 475 F.2d 775, 787 (2d Cir. 1973); NCNB Corp v. United States, 684 F.2d 285 (4th Cir. 1982); Wells Fargo & Co. v. Comm’r, 224 F.3d 874 (8th Cir. 2000).
7 See Priv. Ltr. Rul. 2008-30-009 (July 25, 2008).
Ellen McElroy and Marc D. Nickel
