Corporations & Shareholders
Taxpayers that incur costs relating to an acquisition or restructuring transaction must generally capitalize the costs that “facilitate” the transaction (Regs. Sec. 1.263(a)-5(a)). The regulations provide guidelines for determining whether expenditures facilitate a transaction (Regs. Sec. 1.263(a)-5(b)). For certain acquisitive transactions, this determination may be based on whether the costs were incurred prior to the “bright-line date.” In addition, for “success-based fees”—payments to professional service providers that are contingent upon the successful closing of a transaction—taxpayers may apply a facts-and-circumstances test under Regs. Sec. 1.263(a)-5(b)(1) or a safe harbor to determine the portion of the total fees that is deemed to facilitate the transaction.
Facts-and-Circumstances Test
Regs. Sec. 1.263(a)-5(a) requires a tax payer to capitalize amounts paid to “facilitate” (i.e., paid in the process of investigating or otherwise pursuing) several types of “covered transactions,” including an acquisition of an ownership interest in the taxpayer (but not an acquisition by the taxpayer of an ownership interest in the taxpayer itself, whether by redemption or otherwise). The determination of whether an amount is paid in the process of investigating or otherwise pursuing the transaction is based on all of the facts and circumstances. Except for certain inherently facilitative costs, such as costs of securing an appraisal, structuring and negotiating the transaction, preparing and reviewing the transaction documents, and obtaining regulatory and shareholder approval of the transaction (see Regs. Sec. 1.263(a)-5(e)(2)), Regs. Sec. 1.263(a)-5(e) treats an expenditure as an amount that facilitates a covered transaction only if it relates to activities performed on or after a bright-line date.
A two-part test defines the bright-line date as the earlier of (1) 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 (2) the date on which the material terms of the transaction (as tentatively agreed to by representatives of the acquirer and the target) are authorized or approved by the taxpayer’s board of directors (or committee of the board of directors) (Regs. Sec. 1.263(a)-5(e)(1)).
Covered transactions include, among other things, certain taxable acquisitions of an ownership interest in a business entity (whether the taxpayer is the acquirer or the target) and certain reorganizations described in Sec. 368 (Regs. Sec. 1.263(a)-5(e)(3)).
Determination of Bright-Line Date in CCA 201234026
Chief Counsel Advice (CCA) 201234026 sets forth the IRS’s interpretation of whether a “go-shop” provision in a merger agreement affects when the bright-line date occurs under Regs. Sec. 1.263(a)-5(e). The CCA involved a merger, one of the covered transactions listed in Regs. Sec. 1.263(a)-5(e)(3). “Acquirer,” a corporation, agreed to acquire “Target,” a corporation, in an agreement signed by corporate representatives. The boards of directors of both Acquirer and Target approved the transaction on the same date—March 31, 2012.
The merger agreement contained a go-shop provision under which Target had the right to continue to look for another acquirer for a one-month period, until April 30, 2012. If Target had received a better offer within that period, Acquirer would have had an opportunity to match it, but, if it declined to, Target could have abandoned its agreement with Acquirer and entered into a deal with the alternate acquirer. The merger between Acquirer and Target ultimately closed successfully sometime after April 30, 2012.
The IRS observed that the execution of the merger agreement and its approval by the boards of directors occurred on the same date, March 31, 2012. The go-shop provision was only one of the terms of the merger agreement, and it did not negate the execution of the merger agreement or trump the approval of those terms by the corporations’ boards of directors. Therefore, the IRS concluded that, under these facts, the bright-line date was March 31, 2012, the date the merger agreement was executed and approved by the corporations’ boards of directors.
Critique and Implications of CCA 201234026
The bright-line test in the regulations replaced the so-called whether and which test of Rev. Rul. 99-23. Under that test, a taxpayer was considered to be engaging in predecisional investigatory activities giving rise to deductible costs, rather than facilitative activities resulting in capitalizable costs, if the activities were performed before the taxpayer that incurred the costs (acquirer or target) decided whether to engage in a transaction and in which specific transaction to engage.
The two-part, event-driven test in the current regulations allows the parties to a transaction to reach the bright-line date at some point before the execution of a binding transaction agreement because the events listed in the test can, and sometimes do, occur before a formal and final transaction agreement is executed. It is difficult, however, to generalize about the degree to which one of the other events on the list must be binding (in the sense of subjecting that party to some form of meaningful economic penalty if it does not follow through) and whether it must be binding on the party making the inquiry to trip the bright-line test. Neither the text of the regulations nor the examples elaborate on this point.
One can appreciate the taxpayer’s implicit argument in CCA 201234026 that the go-shop provision logically pushed the bright-line date to April 30 when the taxpayer’s option to find another acquirer lapsed. The inclusion of such a provision in the agreement arguably makes one of the most “material terms” of the transaction—the acquisition price—an unknown variable by giving one party an option to go forward or abandon the deal if it can find a better price. By doing so, it subjects the transaction to a contingency that could call into question the parties’ intent and desire to go through with the transaction.
CCA 201234026 is the first informal guidance from the IRS on the application of the bright-line test and the impact of a contingency affecting the taxpayer’s obligation to complete the transaction in ascertaining when the bright-line date occurs. The IRS’s conclusion on the facts at issue may signal a formalistic reading of the events listed in the two-part test, regardless of how contingent these events may make the completion of the transaction from case to case. Although the bright-line test in the regulations adds some objectivity to the determination, the CCA demonstrates that there are competing views on how to interpret the test, and may be a signal of some continued controversy in this area.
Rev. Proc. 2011-29 Safe Harbor
Regs. Sec. 1.263(a)-5(f) generally presumes that a success-based fee incurred with respect to a covered transaction facilitates the transaction and, thus, must be capitalized, unless the taxpayer rebuts the presumption by maintaining sufficient contemporaneous documentation to establish that a portion of the fee is allocable to activities that did not facilitate the transaction (e.g., activities that were not inherently facilitative and occurred prior to the bright-line date). Because the treatment of success-based fees, including what constitutes “sufficient documentation” for this purpose, had been a continuing area of confusion and controversy, the IRS published Rev. Proc. 2011-29, which set forth a safe-harbor method of accounting for success-based fees.
If a taxpayer elects the safe harbor for a transaction, in lieu of maintaining the required documentation, the taxpayer can treat 70% of the success-based fee as a nonfacilitative cost that is fully deductible, and capitalize the remaining 30%. To make the election, the taxpayer must attach a statement to its original federal income tax return for the tax year during which the fee is paid or incurred, stating that the taxpayer is electing the safe harbor, identifying the transaction and specifying the amounts that are capitalized and the amounts that are deducted because they are treated as nonfacilitative under the safe harbor. The taxpayer must then treat the fees accordingly on its tax return.
Letter Ruling 201250015: Late Election of Safe Harbor
Letter Ruling 201250015 is the first IRS ruling allowing a late election to use the safe-harbor method for success-based fees. In the letter ruling, the taxpayer incurred success-based fees for a covered transaction and capitalized 30% of the fees in accordance with the safe harbor, but it failed to attach the election statement required under Rev. Proc. 2011-29 to its original tax return for the year in which the success-based fees were incurred. The taxpayer discovered this oversight before filing any subsequent tax returns and without the IRS’s discovering it. The taxpayer then requested an extension of time, under Regs. Secs. 301.9100-1 and 301.9100-3, to file the election statement.
In granting the taxpayer’s request for an extension, the IRS considered the requirements for granting relief and concluded that the taxpayer had acted reasonably and in good faith. Moreover, granting relief would not prejudice the government’s interests, because it would neither result in a lower aggregate tax liability for all years affected by the election nor affect any closed tax years. Further, granting relief would not prejudice the governmental interests associated with the special rules for accounting method regulatory elections because the election for success-based fees would be automatic if all proper procedures were followed, did not require a Sec. 481(a) adjustment, and was not an issue under consideration in an examination of any of the taxpayer’s returns. Therefore, the IRS granted the taxpayer an extension of 45 days from the date of the letter ruling to file the election statement with an amended return for the tax year in which the fees were incurred.
Implications of Letter Ruling 201250015
Although a letter ruling applies only to the specific taxpayer to whom it is issued, the ruling can nonetheless be instructive as to how the IRS is likely to rule on similar fact patterns. Thus, it would appear that the IRS is amenable to granting relief and will not view the failure to attach the required election statement as fatal in a situation in which (1) the taxpayer can show that it intended to elect the safe harbor for success-based fees and treated the fees consistent with the intent on a timely filed return; (2) the taxpayer identifies its oversight in a timely manner and before identification by the IRS (e.g., before examination); and (3) the taxpayer requests relief in accordance with the applicable procedures under Regs. Secs. 301.9100-1 and 301.9100-3.
However, it is less clear how the IRS would view such a request if an extended period passed since the filing of the election-year tax return—for example, if the taxpayer has filed one or more tax returns after filing the election-year return. Also, in Letter Ruling 201250015, the taxpayer had applied the safe harbor in determining its taxable income on the original return and thus treated 70% of the contingent fee as nonfacilitative. If the IRS were to grant relief in a situation in which the taxpayer did not claim any deductions or claimed more than 70%, it would appear that the change in treatment from capitalizing to expensing, or vice versa, might be treated as a change in accounting method under the automatic procedures of Rev. Proc. 2011-14 .
EditorNotes
Mary Van Leuven is senior manager, Washington National Tax, at KPMG LLP in Washington, D.C.
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 article represents the views of the author or 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.
