Engagement Letter Fairness Opinion Fee Language May Affect Fees’ Taxation

By John N. Geracimos, J.D., Washington, DC, and Bernita L. Thigpen, J.D., Chicago, IL

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

Expenses & Deductions

Language used in investment banker (IB) engagement letters to implement fee payment arrangements can significantly affect the federal income tax treatment of such payments. However, advance planning regarding drafting may result in more favorable tax treatment. This item discusses the governing tax rules at issue, highlights relevant IB engagement letter language, and recommends principles to consider when drafting such language.

As an historical matter, IBs advising on acquisition transactions charged for their services with a success-based fee model. A company engaging an IB for transaction-related services generally would not pay a fee for the services unless the company consummated a transaction. Generally, the amount paid for such services constituted a percentage of the value of the consummated transaction.

Following the 2007−2008 financial crisis, engagement letters began to reflect the IB’s intention to recover some costs, regardless of whether the clients ultimately consummated a transaction. For example, in addition to a transaction fee (due at closing), post-2008 IB engagement letters often require a fee upon the occurrence of a specific event other than the closing. This fee is often a fairness opinion fee (FO fee) to be paid to the IB when it issues a fairness opinion. The engagement letter language describing the FO fee is often ambiguous as to whether the parties intend the FO fee to be a milestone payment or compensation for the fairness opinion. As discussed below, clearer drafting regarding this intent may help a taxpayer obtain more favorable tax treatment of the FO fee.

Applicable Rules

Regs. Sec. 1.263(a)-5 (the transaction cost regulations) generally require a taxpayer to capitalize, rather than deduct under Sec. 162 or amortize under Sec. 195, costs incurred to investigate or otherwise pursue a variety of corporate transactions (capital transactions). Capital transactions include a taxable or tax-free acquisition of stock or assets of another corporation (or acquisitions of or from the taxpayer), Sec. 355 distributions, borrowings, recapitalizations, and stock issuances. (For more on this topic, see Witner and Casten, “Tax Consequences of Transaction Costs.”)

The transaction cost regulations provide exceptions to the general rule requiring a taxpayer to capitalize costs to facilitate a capital transaction. Most significantly for purposes of this discussion, the transaction cost regulations provide a broad exception for certain costs incurred in connection with certain acquisitive transactions (covered transactions). The taxpayer (whether the acquirer or the target) may expense or amortize rather than capitalize those costs.

The transaction cost regulations generally define a covered transaction to be a taxable acquisition of 50% or more of the stock of a corporation or of the assets of a business or an acquisitive stock or asset reorganization. This exception does not require a taxpayer to capitalize the costs to facilitate a covered transaction if the costs (1) were incurred before a certain date (the bright-line date) and (2) were not on a list of inherently facilitative costs (IF costs). In relevant part, the transaction cost regulations define IF costs to include costs to “secure . . . [a] fairness opinion related to the transaction.”

Therefore, to determine the tax treatment of their IB costs and other transaction costs under the transaction cost regulations, a taxpayer must allocate the costs among the variety of categories, including IF costs, post-bright-line date costs, and pre-bright-line date non-IF costs. However, because IBs generally do not charge their clients on the basis of time spent on various aspects of the project, they generally do not retain time records or present their clients with itemized bills. Accordingly, to facilitate the allocation of costs, an IB generally provides its client a letter (the allocation letter) in which the IB allocates its time spent on the various categories of services described by the transaction cost regulations. The client, as taxpayer, then assembles other supporting documentation to support the IB’s allocation. As a practical matter, because the allocation letter provides the most precise allocation of time, the client tends to rely on this allocation, provided that the allocation is consistent with the other less precise supporting documentation.

Rev. Proc. 2011-29 permits a taxpayer to elect a safe-harbor allocation for certain costs and, in many cases, to avoid the factual allocation described above. More specifically, this revenue procedure, effective for fees paid or incurred in tax years ending on or after April 8, 2011, permits a taxpayer to elect to treat 70% of its costs the payment of which is contingent on the closing of a covered transaction (success-based fees) as not facilitating the transaction and requires the taxpayer to capitalize the remaining 30% as an amount that facilitates the transaction.

Effect of FO Fee Allocation

Under rules of Regs. Sec. 1.263(a)-5, the classification of an FO fee as a milestone payment or an amount paid for the fairness opinion can affect its tax treatment. This classification remains relevant after the adoption of the new 70% safe harbor. However, ambiguity in the IB’s engagement letter can complicate the classification. Consider the following:

Example: Taxpayer Q engages IB, an investment banker, to undertake services in connection with a transaction. The engagement letter requires Q to pay a transaction fee upon the consummation of a transaction based on a percentage of the transaction’s value. The engagement letter also provides for a $1 million FO fee due upon the completion of a fairness opinion, and the FO fee is creditable against the transaction fee. IB presents Q with a fairness opinion, and Q pays the IB $1 million. Ultimately, Q undertakes the transaction and owes IB a $5 million transaction fee, reduced by the $1 million FO fee. When IB undertakes a review of its time spent on the transaction, it determines that it spent 10% of its time on the fairness opinion, 60% on pre-bright-line date non-IF services, and 30% on IF and post-bright-line date services.

If the FO fee is viewed as the amount paid for the fairness opinion, $1 million of the $5 million would be an IF cost that Q must capitalize. That would leave $4 million to be divided among the generally deductible pre-bright-line date non-IF services (60/90, or $2.67 million) and the capitalized post-bright-line date services (30/90, or $1.33 million). If the FO fee is viewed as a milestone payment toward the total payment rather than a payment for the fairness opinion, the allocation would be $500,000 capitalized for the FO fee (10% of $5 million), $3 million for generally deductible pre-bright-line date non-IF services (60% of $5 million), and $1.5 million for capitalized post-bright-line date services (30% of $5 million). Viewing the FO fee as a milestone payment would result in $333,333 greater potentially deductible fees than viewing the FO fee as payment for the fairness opinion.

Generally, if the percentage of time that the IB spends on the FO (the time percentage) is less than the percentage that the FO fee bears to the total fee paid to the IB (the fee percentage), a taxpayer is better off treating the FO fee as a milestone payment than as a fee for the fairness opinion. In working with its corporate counsel to negotiate the language of the IB engagement letter, a taxpayer should consider its past experience in similar situations and consider asking the IB how it anticipates the time percentage will compare with the fee percentage, with an eye toward increasing the deduction of its IB fee.

If Q elected to apply the 70% safe harbor under Rev. Proc. 2011-29 because it applies only to success-based fees, the $1 million would be excluded from its application, regardless of whether it was a milestone payment or a fee for the FO. Accordingly, although it is not entirely clear, it would appear that the $1 million would be capitalized as an IF cost. Also under the election, Q would allocate the remaining $4 million between $2.8 million (70% of $4 million) for a generally deductible nonfacilitative amount and $1.2 million (30% of $4 million) to be capitalized. This results in $200,000 less deduction than not making the election and treating the FO fee as a milestone payment, illustrating that the language of the IB engagement letter remains relevant even after the adoption of the safe harbor.

Frequently, however, taxpayers do not take this allocation issue into account when negotiating engagement letters with IBs. In such cases, it is often unclear from the engagement letter whether the parties intend the FO fee to represent a fee for the services to prepare the fairness opinion or to represent a milestone payment paid for all services rendered. For example, different IB engagement letters may have language similar to the following:

Letter 1: The client shall pay IB a fee of $1 million for the fairness opinion (the opinion fee). In addition, the client will pay to IB at the time of closing a transaction a cash fee of $4 million (transaction fee).

Letter 2: The client shall pay IB a fee of $1 million due and payable upon delivery of the fairness opinion (the opinion fee). In addition, the client will pay to IB at the time of closing a transaction a cash fee of $6 million (transaction fee), reduced by the amount paid for the fairness opinion.

Letter 3: The client shall pay IB a fee of $1 million due and payable upon the earlier of delivery of the fairness opinion (the opinion fee) or the date the transaction is announced (the announcement fee). In addition, the client will pay to IB at the time of closing a transaction a cash fee of $6 million (transaction fee), reduced by the amount of the opinion fee or announcement fee.

In each case, the IB earns $5 million if the client consummates a transaction. The language in letter 1 seems more suggestive of an IF cost, while that in letter 3 seems suggestive of a milestone payment. In all three cases, however, the intent of the parties is unclear from the language, which contains support for either characterization.

More specifically, labeling a payment an FO fee would make it more difficult to assert that the payment is not intended to be compensation for rendering the fairness opinion. In addition, crediting the FO fee against the transaction fee would tend to show that the FO fee is intended to be a milestone payment installment on some total fee amount. In addition, stating that an FO fee is “for” or “in respect of” would be more likely to demonstrate that the parties intended the fee to be consideration for the fairness opinion than the use of language such as “upon the delivery of.” Making the payment of the $1 million fee contingent on the rendering of the fairness opinion or another event suggests that the fee is a milestone payment.

Managing the Issue

Ideally, to avoid this ambiguity, a taxpayer should consider the anticipated relationship between the time percentage and the fee percentage and, in consultation with its corporate counsel, negotiate the language of its IB engagement letter accordingly. If the parties believe that the fee percentage will exceed the time percentage, the parties could consider crafting language reflecting that they intend the FO fee to be treated as a milestone payment. For example, they could label the payment a milestone fee that is payable at the time the IB renders a fairness opinion and specifically state the intent that the fee is intended to be a milestone payment. Making the payment creditable against the transaction fee would also help solidify its treatment as a milestone payment rather than payment for the fairness opinion. The language could also avoid prepositions such as “for” or “in respect of.”

On the other hand, if the parties believe that the time percentage will be larger, they could label the fee a fairness opinion fee, use prepositions that suggest causality such as “for” or “in respect of,” specifically state that the fee is intended to be payment for the fairness opinion, and ideally avoid making the opinion fee creditable against the ultimate transaction fee. The parties also need to consider the effects of making the 70% safe-harbor election.

If the parties do not have a sense of the relative sizes of the fee and time percentages at the time they are drafting their engagement letter, they could take a chance and purposely draft an ambiguous document by inconclusively combining elements of each type of fee. However, taxpayers should be aware that such ambiguity could inure to the benefit of the government as well as to themselves and that the preferable approach would be to seek an understanding of the relationship between the fee percentage and the time percentage, and the effects of a safe-harbor election, before signing the engagement letter with an IB.


Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.

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.

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