IRS Applies Option Rule to Find Covered Transaction for 50% or Less Stock Acquisition

By John Geracimos, J.D., Washington, and Bernita Thigpen, J.D., Chicago

Editor: Mary Van Leuven, J.D., LL.M.

Corporations & Shareholders

Taxpayers generally must capitalize costs incurred to facilitate an acquisition of a target corporation's stock. An exception to this rule exists for a portion of costs incurred in a taxable transaction in which the taxpayer acquires sufficient stock to own more than 50% of the target's stock. A 2014 private letter ruling clarifies that an acquisition after which the acquirer owns 50% or less of the stock of the target can qualify for this exception if the taxpayer has an option to acquire an amount of target stock that, if exercised, would put its ownership of the target above 50%. Taxpayers that incur significant costs for taxable stock acquisitions after which they own less than 50% of the target corporation may want to consider using an option to qualify for this exception to capitalization.

Treatment of Stock Acquisition Costs

Generally, a taxpayer must capitalize costs incurred to facilitate a stock acquisition. However, for taxable stock acquisitions, two sets of rules potentially apply to those costs—Regs. Secs. 1.263(a)-4 and 1.263(a)-5—depending on the amount of stock that the acquiring person owns in the target corporation immediately after the acquisition. The rules of Regs. Sec. 1.263(a)-5 probably give a more favorable result than those of Regs. Sec. 1.263(a)-4. As described below, the use of an option potentially can cause a transaction to be subject to the more favorable Regs. Sec. 1.263(a)-5.

Regs. Sec. 1.263(a)-4

Through a series of nested provisions, Regs. Sec. 1.263(a)-4 requires a taxpayer to capitalize amounts paid to facilitate a stock acquisition. Specifically, Regs. Sec. 1.263(a)-4(b)(1)(v), in relevant part, requires a taxpayer to capitalize an amount paid to facilitate the acquisition of an intangible described in Regs. Sec. 1.263(a)-4(b)(1)(i). Regs. Sec. 1.263(a)-4(b)(1)(i) requires a person to capitalize an amount paid to acquire an intangible described in Regs. Sec. 1.263(a)-4(c). Regs. Sec. 1.263(a)-4(c)(1)(i), in relevant part, requires a person to capitalize an amount paid to acquire an ownership interest in a corporation, limited liability company, or other entity (see also Regs. Sec. 1.263(a)-4(e)(5), Example (4)).

Regs. Sec. 1.263(a)-5

Through a series of nested provisions, Regs. Sec. 1.263(a)-5(a)(2) requires a taxpayer to capitalize an amount paid to facilitate the taxpayer's acquisition of an ownership interest in a business entity if, in relevant part, immediately after the acquisition, the taxpayer and the business entity are related within the meaning of Sec. 267(b). Specifically, Sec. 267(b)(3) defines "related" persons to include two corporations that are members of the same "controlled group" as defined by Sec. 267(f). Sec. 267(f)(1) defines a "controlled group" to have the meaning given by Sec. 1563(a), except, in relevant part, that the "at least 80 percent" threshold in Sec. 1563(a)(1) is revised to be "more than 50 percent." Sec. 1563(a)(1), as modified by Sec. 267(f)(1), defines a "controlled group of corporations" to include a "parent-subsidiary controlled group" that it further defines to consist of one or more chains of corporations connected through stock ownership with a common parent, if more than 50% of the vote and value of each of the corporations, except the common parent, is owned by one or more of the other corporations, and the common parent corporation owns more than 50% of the vote and value of at least one of the other corporations) (see also Regs. Sec. 1.1563-1(a)(2)(ii), Example (3)).

The regulations coordinate the operation of Regs. Secs. 1.263(a)-4 and 1.263(a)-5. Regs. Sec. 1.263(a)-5(a)(2) directs taxpayers to Regs. Sec. 1.263(a)-4 for acquisitions of stock after which the parties are not related within the meaning of Sec. 267(b), Regs. Sec. 1.263(a)-5(a)(2) emphasizes that Regs. Sec. 1.263(a)-4 applies to acquisitions of 50% or less of the stock of a corporation and that Regs. Sec. 1.263(a)-5 applies to acquisitions of greater than 50% of a corporation. Regs. Sec. 1.263(a)-5(b)(2) adds that an amount paid to facilitate a transaction described in Regs. Sec. 1.263(a)-5(a) and an acquisition of an intangible described in Regs. Sec. 1.263(a)-4 is subject to the rules of Regs. Sec. 1.263(a)-5 rather than the rules of Regs. Sec. 1.263(a)-4.

Many of the operative rules of Regs. Sec. 1.263(a)-5 are similar to those of Regs. Sec. 1.263(a)-4. For example, Regs. Sec. 1.263(a)-4(e)(1)(i) and Regs. Sec. 1.263(a)-5(b)(1) both provide that an amount is paid to facilitate a transaction if it is paid in the process of investigating or otherwise pursuing the transaction. However, the key difference between treatments under Regs. Sec. 1.263(a)-4 and Regs. Sec. 1.263(a)-5 is that only the latter provision has the covered transaction exception.

The Covered Transaction Exception

Regs. Sec. 1.263(a)-5 provides an exception to the general rule of capitalization for certain costs paid to facilitate a covered transaction. In relevant part, Regs. Sec. 1.263(a)-5(e)(3) defines a covered transaction as a taxable acquisition of an ownership interest in a business entity (whether the taxpayer is the acquirer in the acquisition or the target of the acquisition) if, immediately after the acquisition, the acquirer and the target are related within the meaning of Sec. 267(b). Generally, Regs. Secs. 1.263(a)-5(e)(1) and (2) provide that amounts paid in the process of investigating or otherwise pursuing a covered transaction must be capitalized only if such amounts are (1) inherently facilitative amounts or (2) related to activities performed on or after the bright-line date (both defined below).

Under the first part of the two-part test, certain types of expenses incurred in connection with a covered transaction are deemed to be inherently facilitative of the covered transaction and, therefore, a taxpayer must capitalize those costs regardless of when they are incurred (inherently facilitative amounts) (see Regs. Sec. 1.263(a)-5(e)(2)). An amount is deemed to be an inherently facilitative amount under Regs. Secs. 1.263(a)-5(e)(2)(i)–(vi) if it is paid in connection with certain specified services:

  • Securing an appraisal, formal written evaluation, or fairness opinion related to a transaction;
  • Structuring the transaction, including negotiating the structure of the transaction and obtaining tax advice on the structure of the transaction;
  • Preparing and reviewing the documents that effectuate a transaction such as a merger agreement or purchase agreement;
  • Obtaining regulatory approval of a transaction, including preparing and reviewing regulatory filings;
  • Obtaining shareholder approval of a transaction, which includes, for example, proxy costs, solicitation costs, and costs to promote the transaction to shareholders; or
  • Conveying property between the parties to the transaction, which includes, for example, transfer taxes and title registration costs.

Under the second part of the two-part test, amounts paid to investigate or otherwise pursue a covered transaction (regardless of whether they are inherently facilitative amounts) are treated as amounts incurred to facilitate a covered transaction and must be capitalized if they are incurred on or after a certain date (referred to here as the bright-line date) (see Regs. Sec. 1.263(a)-5(e)(1)). Regs. Secs. 1.263(a)-5(e)(1)(i)–(ii) defines the bright-line date to be 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 to by representatives of the acquirer and 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, its "appropriate governing officials").

Generally, these rules require a taxpayer that incurs costs to facilitate a covered transaction, which do not fall under another exception to capitalization, to capitalize all the costs incurred on or after the bright-line date and all inherently facilitative amounts regardless of when they are incurred. Considering the other side of the coin, these rules mean that a taxpayer is not required to capitalize its pre-bright-line date non-inherently facilitative amounts and may deduct them under Sec. 162 (which generally allows a taxpayer engaged in a business to deduct all the ordinary and necessary expenses paid or incurred in carrying on that trade or business) or amortize them under Sec. 195 (which generally permits a taxpayer to elect to amortize over 15 years amounts paid or incurred in connection with, in relevant part, investigating the acquisition of an active trade or business that is new to the taxpayer) to the extent that those provisions apply.

Also, in lieu of documenting the bright-line date and inherently facilitative amounts allocation, Rev. Proc. 2011-29 permits a taxpayer that pays or incurs a fee the payment of which is contingent on the consummation of a covered transaction to elect to capitalize only 30% of that success-based fee. Taxpayers making this election may deduct 70% of the success-based fees under Sec. 162 or amortize them under Sec. 195 to the extent that those provisions apply.

Under these rules, a purchaser potentially has significantly different treatment for its payment of costs to facilitate a stock acquisition if the purchaser owns 49% of the stock of the target corporation immediately after the transaction than if it owns 51% of the stock of the target corporation. In the 49% post-transaction ownership scenario, the purchaser generally is required to capitalize all costs incurred to facilitate the acquisition. In the 51% post-transaction ownership situation, the purchaser may deduct or amortize its pre-bright-line date non-inherently facilitative amounts. Moreover, the purchaser in the 51% scenario may elect under Rev. Proc. 2011-29 to capitalize only 30% of its success-based fees, enabling it to deduct or amortize the remaining 70%. The ability to make this election is particularly important because success-based fees paid to investment bankers often represent the most significant costs in a transaction.

The Option Rule and Letter Ruling 201405009

As described below, if an acquiring person has an option to acquire additional target stock, the acquiring person arguably may be treated as owning that stock for purposes of determining whether the transaction is a covered transaction.

As noted above, a transaction is a covered transaction if, immediately after the acquisition, the acquirer and the target are related within the meaning of Sec. 267(b), which ultimately refers to Sec. 1563. In addition to defining the relationship between the parties that will cause them to be related, Sec. 1563 provides that the holder of an option to acquire stock will be treated as owning that stock. Sec. 1563(d)(1)(B) provides that, for purposes of determining whether a corporation is a member of a parent-subsidiary controlled group of corporations within the meaning of Sec. 1563(d)(1), stock owned by a corporation includes, in relevant part, stock owned with the application of Sec. 1563(e)(1). Sec. 1563(e)(1) provides that, "[i]f any person has an option to acquire stock, such stock shall be considered as owned by such person." Therefore, in the case of an acquisition of stock after which the acquiring person owns 50% or less of the stock of the target, an option to acquire sufficient additional target stock could cause the acquisition to be a covered transaction.

Letter Ruling 201405009 clarifies that the IRS believes that the option rule of Sec. 1563(e)(1) applies for purposes of the covered transaction definition. In distilled form, in that ruling, the taxpayer entered into an agreement to acquire stock of Target. In the Step One Acquisition, the taxpayer acquired some percentage of the stock of Target and an option to acquire the remaining Target stock within a specified period beginning a certain number of months after the Step One Acquisition. The exercise of the option is referred to as the Step Two Acquisition. The taxpayer incurred and paid legal and investment banker fees upon the closing of the Step One Acquisition and will pay additional fees upon the closing of the Step Two Acquisition. The ruling did not indicate what the terms of the option were or whether the taxpayer ever exercised the option.

The IRS issued the following rulings:

  • For purposes of Sec. 1563(e)(1), the call option is characterized as an option to acquire an interest in the stock of Target.
  • As a result of the call option, Taxpayer and Target are related within the meaning of Sec. 267(b)(3) immediately after the closing of the Step One Acquisition, and, thus, the Step One Acquisition is a "covered transaction" within the meaning of Regs. Sec. 1.263(a)-5(e)(3)(ii) with respect to Target.

While private letter rulings are not precedent (see Sec. 6110(k)(3)), they do provide insight into the IRS's approach to, and analysis of, federal income tax issues. This ruling is significant because it illustrates that a taxpayer's taxable acquisition of a corporation's stock can constitute a covered transaction, notwithstanding that the taxpayer may have acquired 50% or less of the shares of target stock, provided that the purchaser receives an option that, if exercised, would put the taxpayer's ownership over 50%. The ruling did not state that the option involved in the transaction being ruled on was in the money or that the option holder intended to exercise it, or otherwise describe its terms, suggesting that there may be some flexibility in structuring the terms of the option. Nevertheless, taxpayers should take care in structuring the option so that it is not disregarded as a sham.

EditorNotes

Mary Van Leuven is director, Washington National Tax, at KPMG LLP in Washington.

For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or mvanleuven@kpmg.com.

Unless otherwise noted, contributors are members of or associated with KPMG LLP.

This column represents the views of the authors only and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. ©2015 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

Newsletter Articles

SPONSORED REPORT

Year-End Tax Planning and What’s New for 2016

A look at year-end tax planning strategies for individuals and businesses, as well as recent federal tax law changes affecting this year’s tax returns.

PRACTICE MANAGEMENT

CPAs Contend With Tax ID Theft

Tax-related identity theft fraud remains a widespread problem that is often difficult for victims and their tax preparers to correct.