On April 8, 2011, the IRS issued Rev. Proc. 2011-29, which provides a safe harbor for success-based fees incurred in connection with covered transactions under Regs. Sec. 1.263(a)-5(e)(3). Specifically, in lieu of satisfying the documentation requirements of Regs. Sec. 1.263(a)-5(f) to support a deduction for a portion of a success-based fee, Rev. Proc. 2011-29 permits an electing taxpayer to treat 70% of the success-based fee as an amount that does not facilitate the transaction, while the remaining 30% of the fee is treated as facilitating the transaction, and hence, must be capitalized. Rev. Proc. 2011-29 applies only to success-based fees, that is, fees due and payable upon the successful closing of the transaction and, therefore, does not provide a safe harbor for milestone payments. However, the IRS Large Business and International (LB&I) Division recently issued a memorandum providing that it will not challenge a taxpayer's application of this success-based fee safe harbor to certain "milestone payments" so long as specific criteria are met (LB&I-04-0413-002).
In general, a milestone payment is an amount paid upon the occurrence of a certain event, such as the issuance of a fairness opinion, the creation of a "bid" book, or the execution of a letter of intent, among other things. Investment bankers and attorneys who work on a transaction may require payments from their clients (the buyer or seller) for such "milestones" before closing. As such, these payments for services rendered are not contingent upon the successful closing of the transaction. In a success-based fee context, these payments are generally creditable against the total amount due and payable for a consummated transaction but are not refundable if the transaction is abandoned.
According to the IRS directive, for purposes of the safe harbor, the term "milestone payment" means a nonrefundable amount payable for investment banking services that is creditable against a success-based fee and contingent upon the achievement of a milestone. A "milestone" is an event occurring in the course of a covered transaction (whether consummated or not), provided that the event is (1) the execution of an agreement described in Regs. Sec. 1.263(a)-5(e)(1)(i) (i.e., letter of intent, exclusivity agreement, or similar written communication other than a confidentiality agreement); (2) an event described in Regs. Sec. 1.263(a)-5(e)(1)(ii) (the date on which the material terms of the transaction are tentatively agreed to by the taxpayer's board of directors); or (3) some other specified event other than the successful closing of the transaction, provided that the event does not occur before any event described in Regs. Sec. 1.263(a)-5(e)(1)(i) or (ii). Further, any amount that is payable even if the milestone is not achieved is not a "milestone payment" for purposes of the safe harbor, regardless of whether the amount is creditable against the amount due on the milestone payment.
Therefore, according to the directive, to be eligible for the safe harbor, a milestone cannot occur before the "bright-line" date for covered transactions (i.e., the date that the letter of intent or exclusivity agreement is executed or the board approves the material terms of the transaction). Further, the taxpayer must (1) have qualified for and timely elected the Rev. Proc. 2011-29 safe harbor for the covered transaction; (2) not have deducted more than 70% of any eligible milestone payment incurred in connection with the respective success-based fee on its original tax return for the year in which the taxpayer's liability for the eligible milestone payment accrued; and (3) not be contesting its liability for the eligible milestone payment. Where a taxpayer otherwise makes eligible milestone payments in a tax year preceding the year in which the success-based fee would be paid (e.g., because the covered transaction spans multiple years), the taxpayer must satisfy (2) and (3) above as well as have documented, in the year in which eligible milestone payments were made, its intent to elect Rev. Proc. 2011-29 for the related success-based fee and have in fact made the election for the success-based fee that was paid or incurred. If the taxpayer meets the foregoing requirements, LB&I examiners are directed not to challenge a taxpayer's application of the safe harbor to eligible milestone payments.
In summary, under the IRS's directive, a milestone payment is eligible for the 70% safe-harbor treatment if it is:
- Paid in connection with a "covered" transaction;
- Paid for investment banking services;
- Paid for an event that occurs after the bright-line date;
- Nonrefundable; and,
- Creditable against a success-based fee. (As indicated, the taxpayer must also have timely elected the Rev. Proc. 2011-29 safe harbor and not deducted more than 70% of the eligible milestone payment on its original return for the year in which the payment accrued as well as not be contesting its liability for the milestone payment.)
Given the IRS's specific guidelines on what constitutes an eligible milestone, many common milestone payments will not be eligible for the safe-harbor treatment. For example, milestone payments for executed merger agreements or shareholder approvals are events that occur after the bright-line date and are hence eligible under the directive. However, payments for a "fairness opinion" or a "bid" book—two common milestone events that occur before the bright-line date—would not be eligible for the safe-harbor treatment. Further, payments for post-bright-line events (executed agreement; shareholder approval) would still not be eligible for the safe harbor if, for example, they were paid to a law firm and not for investment banking services, were refundable, or were not creditable against a success-based fee. Therefore, tax practitioners attempting to determine what milestone payments are eligible for the 70% safe-harbor treatment under Rev. Proc. 2011-29 must carefully review the terms and conditions of payments made to investment bankers to ensure that those payments meet the IRS directive's criteria and thus will not be challenged on examination.
Alan Wong is a senior manager–tax with Baker Tilly Virchow Krause LLP in New York City.
For additional information about these items, contact Mr. Wong at 212-792-4986 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP