In Chief Counsel Advice (CCA) 201830011, the IRS concluded that a taxpayer was required to capitalize 100% of an investment banking fee because it failed to satisfy the documentation requirement for success-based fees under Regs. Sec. 1.263(a)-5.
Under Regs. Sec. 1.263(a)-5(a), a taxpayer must capitalize an amount paid to facilitate an acquisition of a trade or business, a change in the capital structure of a business entity, and certain other transactions. An amount is paid to facilitate a transaction if it is paid in the process of investigating or otherwise pursuing the transaction.
The regulations require taxpayers to satisfy a special documentation requirement for success-based fees, which are amounts paid that are contingent on the successful closing of a transaction. Under Regs. Sec. 1.263(a)-5(f), a success-based fee is treated as facilitative, and therefore capitalized, unless the taxpayer maintains sufficient documentation to establish that a portion of the fee is allocable to activities that do not facilitate the transaction. Such documentation must consist of more than merely an allocation between activities that facilitate the transaction and activities that do not facilitate the transaction.
The regulations do not mandate that certain types of records be included, but they do state that the documentation must consist of supporting records (e.g., time records, itemized invoices, or other records) that identify (1) the activities performed by the service provider; (2) the amount of the fee (or percentage of time) that is allocable to each of the various activities performed; (3) where the date the activity was performed is relevant to understanding whether the activity facilitated the transaction, the amount of the fee (or percentage of time) that is allocable to the performance of that activity before and after the relevant date; and (4) the name, business address, and business telephone number of the service provider.
Taxpayers that engage in a "covered transaction" may take advantage of a safe harbor provided by Rev. Proc. 2011-29, which allows those taxpayers to avoid the documentation rules as long as they treat 70% of the success-based fee as an amount that does not facilitate the transaction and capitalize the remainder as facilitative. A covered transaction is (1) a taxable acquisition by the taxpayer of assets that constitute a trade or business; (2) a taxable acquisition of at least 50% of the ownership interest in a business entity; or (3) certain nontaxable reorganizations.
In the CCA, the taxpayer engaged an investment banker to help it identify potential buyers. After the transaction closed, the taxpayer paid the investment banker a success-based fee. The investment banker provided the taxpayer with a letter in which it estimated the amount of time it spent on various activities relating to the transaction as follows: 92% of its time on identifying a buyer; 2% of its time on drafting a fairness opinion; 4% of its time on reviewing drafts of the merger agreement; and 2% of its time on performing services after the identified bright-line date. The investment banker included in the statement a caveat that the percentages were merely estimates and should not be relied on by the taxpayer.
On its federal income tax return, the taxpayer did not elect the safe harbor provided in Rev. Proc. 2011-29 for allocating success-based fees, which would have allowed the taxpayer to treat 70% of the success-based fee as an amount that did not facilitate the transaction and 30% of the success-based fee as an amount that did facilitate the transaction. Instead, the taxpayer treated 92% of the success-based fee as nonfacilitative based on the investment banker's letter.
On audit, the taxpayer provided the investment banker's estimate as documentation under Regs. Sec. 1.263(a)-5(f). When the IRS requested more documentation, the taxpayer provided a PowerPoint presentation that the investment banker presented to the taxpayer's boards and that contained basic information regarding the taxpayer and explored possible acquisition strategies.
The IRS concluded that the taxpayer failed to meet the documentation requirement and was required to treat 100% of the success-based fee as an amount that facilitated the transaction. In so concluding, the IRS stated that the investment banker's letter was insufficient because it was "merely an allocation between activities that facilitated and did not facilitate the transaction." The IRS also noted that the PowerPoint presentation was insufficient documentation because it did not identify the amount of the fee or the percentage of time that was allocable to each activity.
This CCA demonstrates some uncertainty about the IRS view on whether a taxpayer has met the documentation requirement for a success-based fee. Taxpayers that engage in covered transactions should be aware of the Rev. Proc. 2011-29 safe harbor and consider that approach. Taxpayers that attempt to meet the documentation requirement instead should ensure that they have adequately supported their allocation.
In IRS Letter Rulings 200830009 and 200953014, the IRS ruled that time records are not always necessary to support an allocation. In Technical Advice Memorandum 201002036, the IRS advised that allocation spreadsheets completed by service providers allocating their time between facilitative and nonfacilitative activities are generally "other records" that are an acceptable form of supporting documentation for an allocation, but that the determination of whether the documentation requirement is met is based on all the supporting documentation provided by the taxpayer. Examples of evidence used to substantiate an allocation may include retainer agreements, invoices, lists of potential buyers, transaction timelines, presentations, meeting agendas, taxpayer records, the files of the attorneys, board meeting minutes, and presentations.
Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington..
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or firstname.lastname@example.org.
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