The treatment of success-based fees and, in particular, the type and extent of documentation required to establish that a portion of a success-based fee is allocable to activities that do not facilitate the transaction, has been a subject of much controversy between the IRS and taxpayers.
Success-based fees are amounts that are contingent on the successful closing of a transaction (i.e., usually the investment banker or other financial adviser fee), and they are presumed to be facilitative unless the requisite documentation of their allocation to nonfacilitative activities is provided. Amounts paid to facilitate a transaction are generally required to be capitalized, while amounts paid for nonfacilitative activities are generally deductible under Sec. 162 or amortizable under Sec. 195.
Rev. Proc. 2011-29, issued on April 8, 2011, permits electing taxpayers to treat 70% of success-based fees as nonfacilitative. Taxpayers must capitalize the remaining 30% as an amount that facilitates the transaction. The revenue procedure is effective for success-based fees paid or incurred in tax years ending after April 7, 2011.
A recent directive instructs Large Business and International (LB&I) examiners not to challenge the treatment of success-based fees incurred or paid in tax years ending before April 8, 2011, if the taxpayer capitalized at least 30% of the total success-based fees incurred on the transaction on its originally filed return.
As discussed further below, for affected taxpayers, the directive may have tax accounting consequences in connection with income tax uncertainty associated with success-based fees.
Regs. Sec. 1.263(a)-5 requires a taxpayer to capitalize an amount paid to facilitate a business acquisition or reorganization transaction described in Regs. Sec. 1.263(a)-5(a). In general, an amount is paid to facilitate a transaction if the taxpayer pays it in the process of investigating or otherwise pursuing the transaction.
Regs. Sec. 1.263(a)-5(e) provides a bright-line rule for determining whether certain investigatory costs are facilitative. Under the bright-line rule, a taxpayer may treat a portion of the transaction costs as not facilitating the transaction and thus deduct or amortize them, as applicable. This rule applies only to transactions identified as “covered transactions” in Regs. Sec. 1.263(a)-5(e)(3).
Under Regs. Sec. 1.263(a)-5(f), an amount that is contingent on the successful closing of a transaction (i.e., success-based fee) is presumed to facilitate the transaction. The taxpayer may rebut that presumption by providing sufficient documentation to establish that a portion of the fee is allocable to activities that do not facilitate the transaction.
Safe-Harbor Election Under Rev. Proc. 2011-29
Rev. Proc. 2011-29 establishes a safe-harbor election, in lieu of the documentation described in Regs. Sec. 1.263(a)-5(f), for allocating success-based fees between facilitative and nonfacilitative activities. Rev. Proc. 2011-29 applies only to success-based fees (i.e., usually the investment banker or other financial adviser fee), and is effective for success-based fees paid or incurred in tax years ending after April 7, 2011.
The revenue procedure provides that the IRS will not challenge a taxpayer’s allocation of a success-based fee between activities that facilitate a “covered” transaction, as defined in Regs. Sec. 1.263(a)-5(e)(3), and activities that do not facilitate the transaction if the taxpayer:
- Treats 70% of the success-based fee amount as an amount that does not facilitate the transaction (e.g., costs deducted or amortized);
- Capitalizes the remaining 30% as an amount that does facilitate the transaction; and
- Attaches a statement to its original federal income tax return for the tax year in which the success-based fee is paid or incurred that states the taxpayer is electing the safe harbor, identifies the transaction, and indicates the success-based fee amounts that are deducted and capitalized.
An election made under Rev. Proc. 2011-29 applies only to the transaction for which the taxpayer makes the election. Once made, the election is irrevocable and applies to all success-based fees paid or incurred by the taxpayer in the transaction for which the election is made.
Tax Years Ending Before April 8, 2011
In LB&I-04-0511-012, LB&I management has directed LB&I examiners not to challenge the treatment of success-based fees incurred or paid in a covered transaction in tax years ending before April 8, 2011, if the taxpayer capitalized at least 30% of the total success-based fees incurred in the transaction.
The directive applies only to original timely filed returns and not to claims, whether formal or informal. The directive states that it is not an official pronouncement of the law or position of the IRS and cannot be used, cited, or relied upon as such.
Tax Return Level-of-Confidence Considerations
The directive is not authority for purposes of determining the level of confidence (e.g., substantial authority (assuming the underlying transaction is not a significant-purpose transaction)) that the requirements of Regs. Sec. 1.263(a)-5(f) have been met for any portion of the success-based fee that is treated as not facilitating the transaction. Level of confidence is generally determined by weighing the various tax authorities related to a particular tax position.
Regs. Sec. 1.6662-4(d)(3)(iii) sets forth the types of authorities that are considered in determining the level of confidence. Such authorities include, but are not limited to, revenue rulings, revenue procedures, and notices and announcements published in the Internal Revenue Bulletin. Because the directive is not an authority for this purpose, the determination of the level of support for the treatment of success-based fees will be based on the authorities relevant to the tax year applied to the taxpayer’s facts and circumstances.
Tax Accounting Considerations
Entities should consider the potential effects of the IRS’s LB&I exam position when evaluating the income tax uncertainty associated with success-based fees, taking into account their specific facts and circumstances. To the extent a liability has been recorded in periods ending prior to April 8, 2011, the directive may provide new information that may result in a change in judgment with respect to recognition and/or measurement of an uncertain tax position.
FASB Accounting Standards Codification (ASC) ¶740-10-25-14 emphasizes basing a change in judgment as to recognition or measurement on new information rather than simply changing an interpretation or evaluation of previous information. As a result, changes related to recognition and measurements are expected to be supported by triggering events in the form of new information.
Changes in judgment that result in the subsequent recognition or changes in measurement of a tax position that was taken in a previous annual period (including any interest and penalties) are considered discrete events and are recognized in earnings in the period (interim as well as annual) the change occurs. A change in judgment related to a tax position taken in prior interim periods of the current year is an integral part of an annual period and should be accounted for under the guidance on interim reporting in ASC Topic 740, Income Taxes (i.e., included in the estimated annual effective tax rate).
For further discussion, see Sections T1707.5, New information vs. new evaluation; T1707.6, Changes in judgment; and T1707.9, Interim reporting, of Ernst & Young’s publication Financial Reporting Developments: Accounting for Income Taxes (December 2009).
Michael Dell is a partner at Ernst & Young LLP in Washington, DC.
For additional information about these items, contact Mr. Dell at (202) 327-8788 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.