The IRS concluded in Letter Ruling 201518012 that a payment made to terminate a management services agreement did not create an intangible asset or facilitate a transaction and, therefore, did not have to be capitalized under Sec. 263.
Subsequent to undertaking an acquisition and bankruptcy reorganization, a group of corporations (Taxpayer) and an affiliate of the Taxpayer's sole owner (Manager) entered into a management services agreement under which, in exchange for a monthly fee, the Manager agreed to provide certain services (monitoring services) regularly to help the Taxpayer govern and oversee its business. These services included activities such as participation on the Taxpayer's board and in monthly meetings; assistance to develop the Taxpayer's general corporate strategy and corporate governance functions; the provision of finance, tax, managerial, and operational oversight; mergers and acquisitions advice and support; and oversight and strategic support of the Taxpayer's internal and external legal services, facilities, sales, marketing, customer support, and human resources functions. The management services agreement, which was renewed for additional terms, did not prohibit the Taxpayer and the Manager from entering into contracts with other service providers or companies, so the management services agreement did not provide either party with an exclusive right.
Based on the Taxpayer's financial growth and rejuvenated business model, both the Taxpayer and the Manager eventually agreed to terminate the management services agreement. The termination agreement provided that upon the consummation of an underwritten (firm commitment) public offering resulting in the listing or quotation of the Taxpayer's stock on one or more nationally recognized stock exchange or quotation systems, the Taxpayer would pay a termination fee to the Manager in consideration for all amounts owing under the management services agreement.
However, the Manager's receipt of the termination fee payment was not dependent upon a successful public offering. The termination fee was in part intended to compensate the Manager for having agreed to receive less than the amounts it would have ordinarily charged over the course of providing its services to the Taxpayer because the Taxpayer had just emerged from bankruptcy. In addition, the termination fee compensated the Manager for having successfully turned the Taxpayer's operations into a profitable business. No part of the termination fee represented a payment to terminate an exclusive right for the Taxpayer to use, or for the Manager to provide, the monitoring services.
Upon completion of the initial public offering (IPO), the Taxpayer used a portion of the net proceeds from the IPO to pay the termination fee. However, even if the IPO had not occurred, the Taxpayer had the financial wherewithal to pay the termination fee to the Manager. In determining whether to undertake the IPO, none of the investment bankers, the Taxpayer, or the Manager required the Taxpayer to pay the termination fee as a condition of going forward with the offering (i.e., the Taxpayer's payment of the termination fee was not a prerequisite to implementing the IPO). The Manager did not have expertise in implementing IPOs and did not assist with any of the activities generally associated with undertaking a stock offering—for example, pricing, valuation, preparing roadshow decks and banker presentations, or creating assumptions and projections—or in complying with any of the filing requirements necessary to list a company's shares of stock on an exchange.
The Taxpayer further represented that (1) the termination fee did not exceed the value of the services the Manager provided to the Taxpayer; (2) the Taxpayer treated the termination fee as an expense for financial accounting purposes; (3) the Taxpayer treated the monitoring fee as an expense for financial accounting purposes and for federal income tax purposes; and (4) the Taxpayer was not prohibited from entering into a contract or other arrangement with any third-party services provider (other than the Manager or its affiliates) during the time the management services agreement was in effect.
Amounts Paid to Acquire or Create Intangibles
Sec. 263(a) generally requires capitalization of amounts paid for permanent improvements or betterments made to increase the value of any property. Regs. Sec. 1.263(a)-4 provides rules for applying the Sec. 263 capitalization standard to amounts paid to acquire or create intangibles.
Regs. Sec. 1.263(a)-4(b)(1) generally requires capitalization of an amount paid to (1) acquire or create an intangible; (2) create or enhance a separate and distinct intangible asset or a future benefit identified in published guidance as an intangible requiring capitalization; or (3) facilitate the acquisition or creation of an intangible.
Regs. Sec. 1.263(a)-4(d)(7)(i), pertaining to created intangibles, generally requires capitalization of amounts paid to another party to terminate the following agreements: (1) a lease of real or tangible personal property between the taxpayer (as lessor) and the other party (as lessee); (2) an agreement that grants the other party the exclusive right to acquire or use the taxpayer's property or services or to conduct the taxpayer's business; or (3) an agreement that prohibits the taxpayer from competing with the other party or from acquiring property or services from a competitor of the other party.
Amounts Paid or Incurred to Facilitate Certain Transactions
Regs. Sec. 1.263(a)-5 provides rules for applying the capitalization provisions under Sec. 263 to amounts paid or incurred to facilitate certain transactions described in Regs. Sec. 1.263(a)-5(a), such as a business acquisition, reorganization, merger, and a stock issuance (e.g., an IPO).
Regs. Sec. 1.263(a)-5(b) generally defines the term "facilitate" to include an amount paid in the process of investigating or otherwise pursuing the transaction, determined based on all of the facts and circumstances. One of the relevant factors, although not determinative, is whether the amount would (or would not) have been paid but for the transaction.
Termination Payment Did Not Create an Intangible
Applying the definitional provisions outlined in Regs. Sec. 1.263(a)-4 to the Taxpayer's facts, the IRS concluded that payment of the termination fee did not create an intangible asset as described in Regs. Sec. 1.263(a)-4(d)(7)(i)(B) because the terms of the management services agreement did not grant either party (i.e., the Taxpayer or the Manager) the "exclusive right to acquire or use the taxpayer's property or services or to conduct the taxpayer's business." Specifically, the management services agreement did not provide the Taxpayer with an exclusive right to receive, or the Manager with an exclusive right to render, the monitoring services, and therefore the termination fee paid by the Taxpayer to the Manager to end the arrangement did not create an intangible asset requiring capitalization within the meaning of Regs. Sec. 1.263(a)-4.
Termination Payment Did Not Facilitate the IPO
In addition, the IRS concluded that capitalization of the termination fee was not required under Regs. Sec. 1.263(a)-5 because it was not incurred in "the process of investigating or otherwise pursuing the transaction" and therefore did not "facilitate" the IPO within the meaning of Regs. Sec. 1.263(a)-5(b). Specifically, the IRS noted, based on the facts and representations submitted by the Taxpayer, the termination fee pertained to prior services, rather than to services rendered "in the process of investigating or otherwise pursuing" (i.e., facilitating) the transaction.
The IRS also found that the payment of the termination fee was not a condition necessary to undertake the IPO. Consequently, citing the holding in A.E. Staley Manufacturing Co., 119 F.3d 482 (7th Cir. 1997), rev'g 105 T.C. 166 (1995), the IRS stated that "fees associated with general activities not directly related to the capital transaction must be treated differently," and ruled that, although the services that triggered the termination payment may have provided an indirect, ancillary benefit by putting the Taxpayer "in a better position . . . to undertake the IPO as a result of certain internal management strategies that had been initiated by the manager," the services that triggered the termination fee were not sufficiently connected to the IPO transaction to meet the "facilitative" standard outlined in Regs. Sec. 1.263(a)-5(b).
Furthermore, in analyzing the regulatory criteria of "whether the amount would (or would not) have been paid but for the transaction," the IRS liberally interpreted this provision in applying it to the Taxpayer's specific facts, ruling favorably that "although Taxpayer's obligation to pay the Termination Fee was in part dependent upon whether or not a public offering occurred, the Termination Fee was not paid to facilitate the IPO."
Implications
The favorable rulings provide welcome and useful insight as to how the IRS applies the facts and circumstances based on rules under Regs. Secs. 1.263(a)-4 and 1.263(a)-5 in analyzing the tax treatment of payments made to terminate a nonexclusive service agreement before implementing a transaction. Accordingly, the letter ruling may assist similarly situated taxpayers with structuring these arrangements and conducting activities to avoid having to capitalize their termination payments by adhering to the following practices:
- The services agreement contains no exclusivity provisions such as those described in Regs. Sec. 1.263(a)-4(d)(7)(i)(B) (i.e., that prohibit the taxpayer from entering into a contract or other arrangement with any third-party service provider or otherwise grant an exclusive right to acquire or use the taxpayer's property or services or to conduct the taxpayer's business). Note that when considering the applicability of Regs. Sec. 1.263(a)-4, taxpayers are advised to carefully review all provisions under Regs. Sec. 1.263(a)-4 because multiple rules govern the treatment of termination payments under various factual scenarios (see, e.g., Regs. Sec. 1.263(a)-4(f)(2), which applies to amounts paid to terminate or facilitate termination of a contract or other agreement described in Regs. Sec. 1.263(a)-4(d)(7)(i) prior to its expiration date).
- Payment of a termination fee is not contingent upon the undertaking of a transaction or vice versa (i.e., payment of the termination fee should not be a prerequisite to implementing the transaction).
- The taxpayer's ability to finance the termination fee regardless of whether the transaction is implemented is verified and documented.
- The service provider avoids performing activities associated with undertaking (i.e., facilitating) the transaction—for example, investigatory and due-diligence-related activities or inherently facilitative tasks such as valuation, structuring, preparing, or negotiating the transaction documents, obtaining shareholder or regulatory approval for the transaction, etc.
- The termination fee does not exceed the value of the management services provided.
- The termination fee is accounted for as an expense for financial accounting purposes and, similarly, the management services fee is treated as an expense for both financial accounting purposes and federal income tax purposes.
EditorNotes
Mark Heroux is a principal with the Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or mark.heroux@bakertilly.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.
