Deductibility of transaction costs incurred by an indirectly acquired entity

Editor: Greg A. Fairbanks, J.D., LL.M.

Expenses incurred by a buyer or target while pursuing a merger or acquisition (M&A) transaction are subject to various rules that limit the deductibility of such costs as incurred. These rules include Regs. Sec. 1.263(a)-5 and Sec. 195, which provide the framework for the treatment of expenses incurred in M&A transactions and help determine whether expenses may be deducted or must be capitalized as a result of the transaction for both buyers and sellers.

One important issue in determining the deductibility of transaction costs that is not thoroughly addressed by Regs. Sec. 1.263(a)-5 and subsequent IRS guidance is which is the proper party to account for expenses in transactions where multiple entities are involved in the transaction process. While case law such as Square D Co.,121 T.C. 168 (2003), has addressed which is the proper party to take into account an expense that was incurred on behalf of such a party, guidance in the application of such rules to transaction expenses has been limited. In IRS Letter Rulings 202443001 and 202448003, the Service indirectly addressed a situation in which it is unclear under Regs. Sec. 1.263(a)-5 which taxpayer takes into account target–side transaction expenses. The letter rulings indicate that the target under Regs. Sec. 1.263(a)-5 may not always be the entity that was directly acquired in a transaction.

Rules

The general rule under Regs. Sec. 1.263(a)-5 requires taxpayers to capitalize amounts paid to facilitate certain transactions without regard to whether gain or loss is recognized in the transaction. Under Regs. Sec. 1.263(a)-5(e)(3), for “covered transactions,” the IRS provides additional guidance as to what is considered a cost that facilitates the transaction. For it to qualify as a covered transaction, the taxpayer must be engaged in one of the following: (1) a taxable acquisition by the taxpayer of assets that constitute a trade or business; (2) a taxable acquisition of an ownership interest in a business entity, regardless of whether the taxpayer is the acquirer or the target if, immediately after the acquisition, the acquirer and the target are related within the meaning of Sec. 267(b) or 707(b); or (3) a reorganization described in Sec. 368(a)(1)(A), (B), or (C) or a reorganization described in Sec. 368(a)(1)(D) in which stock or securities of the corporation to which the assets are transferred are distributed in a transaction that qualifies under Sec. 354 or 356 (whether the taxpayer is the acquirer or the target in the reorganization). For covered transactions, the IRS has also issued a safe–harbor provision in Rev. Proc. 2011–29, under which electing taxpayers are permitted to treat 70% of any success–based fee (fees that were contingent upon the successful closing of the transaction) as an amount that does not facilitate the transaction (potentially leading to the amount being deducted by the taxpayer).

While Regs. Sec. 1.263(a)-5 addresses the treatment of transaction costs for the acquirer and target, Regs. Sec. 1.263(a)-5 fails to define “acquirer” and “target,” which can be difficult to determine when multiple entities are involved in the transaction. In a simple transaction, it may be easy to identify buyer and target costs, as each party likely engages the service providers directly. However, in a transaction where multiple entities or a consolidated group is involved, a lower–tier entity that is not the buyer or target identified in the agreement may incur, engage, and pay service providers involved in pursuing and investigating the transaction. Historically, there has been uncertainty surrounding the treatment of expenses incurred by these lower–tier entities and the proper party to take a deduction.

Prior case law has addressed the proper party to take a deduction more generally. In Hood,115 T.C. 172 (2000),the Tax Courtapplied the “primary benefit” standard in deciding that a corporation was not entitled to deduct the legal fees incurred by its sole shareholder. In Hood, the court stated that the proper party to take a deduction is the one that receives the direct and proximate benefit; however, there is still uncertainty in how to apply this case law in the transaction–cost context.

Analysis

The IRS provided some guidance in Letter Ruling 202443001, where an indirectly acquired entity was permitted to take deductions for costs incurred related to the acquisition by Parent, a corporate owner of an affiliated group of corporations that filed a consolidated federal income tax return. While this letter ruling did not directly address the issue of which was the proper party to take into account expenses from a transaction, the IRS granted relief under Regs. Sec. 301.9100–3 to permit the taxpayer to make a safe–harbor election under Rev. Proc. 2011–29, which should be permitted only if the taxpayer was the proper party to take into account the transaction expenses.

In the letter ruling, the taxpayer, a limited liability company taxed as a partnership for federal income tax purposes, was owned directly by two corporate holding companies (Holdcos), which were owned by multiple shareholders (Sellers). The stock of the Holdcos was acquired by a disregarded entity of a corporation (Buyer) from the Sellers. In the letter ruling, the taxpayer (the partnership held by the Holdcos) represented that the Holdcos did not sell their interests in the taxpayer, but rather, Sellers sold their stock interests in Holdcos to Buyer.

In connection with the transaction, the taxpayer engaged a financial adviser to assist in investigating and pursuing the transaction. The financial adviser’s fees were contingent upon the successful closing of the transaction, and the financial adviser was paid by a payment agent from the transaction closing payment funds flow.

After the consummation of the transaction, Parent engaged an accounting firm to prepare the tax returns for the taxpayer and Holdcos. On its tax return including the date of the transaction, the taxpayer failed to properly elect safe–harbor treatment under Rev. Proc. 2011–29 and capitalized the entire success–based fee. The taxpayer then sought relief from the IRS under Regs. Sec. 301.9100–3 to be permitted to make a late election under Rev. Proc. 2011–29. The IRS granted the taxpayer relief to elect success–based treatment for the contingent fees under Regs. Sec. 301.9100–3, finding that the taxpayer acted in good faith and relief would not prejudice the interests of the government. While the proper party to take into account the transaction expenses was not directly addressed by the IRS in its conclusion — and the IRS even specifically stated that it expressed no opinion as to whether the taxpayer was the proper legal party to make the safe–harbor election and claim the deduction — the IRS has denied granting relief under Regs. Sec. 301.9100–3 when it believed the taxpayer was the incorrect party to account for such expense (see, e.g., Letter Ruling 202308010).

Additionally, in Letter Ruling 202448003, the IRS held that an indirectly acquired entity was the proper party to take into account transaction expenses when an interest in its holding company, which was a partnership, was sold, and the IRS permitted the expense to be taken at the level of the lower–tier corporation that the partnership held.

Commentary

As stated above, a covered transaction includes a taxable acquisition of an ownership interest in a business entity where the acquirer and target are related immediately afterward, under Sec. 267(b) or 707(b). In a transaction such as Letter Ruling 202443001, where two holding companies are directly acquired and own an operating entity, it is unclear under the regulations whether the directly acquired holding company should be treated as the “target” referenced in the regulations or whether the definition of “target” extends to the operating entity indirectly acquired as a result of the transaction.

While the IRS did not directly conclude whether the transaction in Letter Ruling 202443001 qualified as a covered transaction or whether the taxpayer was the proper party to take the deduction, the Service accepted a representation that the transaction constituted a covered transaction between the taxpayer and Buyer, which the Service would not likely have accepted if it took issue with the substantive legal conclusion that Target was the proper party to take into account the transaction expenses. Particularly considering that the proper party to take transaction expenses was recently indicated as the reason a letter ruling was denied (see Letter Ruling 202308010), the Service’s granting of relief seems to indicate support for the position that the proper party to take expenses related to a transaction is not required to be the entity that was directly acquired by the buyer.

A question remains, then, whether the rationale applied in the aforementioned letter rulings is appropriate in other transaction–cost–analysis situations. For instance, which entity would be the proper taxpayer to deduct acquirer costs related to acquisitions of multinational groups where the acquired entities are ultimately acquired by different acquirers within the buyer group? In addition, questions still remain in other situations where the proper party to take into account transaction costs is uncertain, such as which is the proper party to take into account acquirer costs related to a partnership acquisition in which the legal acquirer is treated as a continuation of the target partnership. Additional guidance is needed to understand which is the proper party to take into account the transaction expenses in such variations. The letter rulings above provide an indication of the IRS’s views for their specific fact patterns; however, many questions are unresolved for variations of their fact patterns.

Editor

Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact Fairbanks at greg.fairbanks@us.gt.com.

Contributors are members of or associated with Grant Thornton LLP.