California CPA: October 2011
IRS Revenue Procedure & Directive Offer Favorable Taxpayer Developments
By Jeffrey M. Hurok
Revenue Procedure 2011-29, released by the IRS April 8, addresses the federal income tax treatment of success-based fees incurred in connection with certain acquisitive transactions for fees incurred within taxable years ending on or after April 8, 2011.
Rev. Proc. 2011-29 provides a safe harbor that may simplify the analysis of—and potentially results in—favorable treatment for fees within its scope. However, one must keep in mind that it does not address the treatment of all acquisition cost issues. Also, a taxpayer may be entitled to more favorable treatment than the revenue procedure provides.
Accordingly, Rev. Proc. 2011-29 complements, rather than replaces, an analysis of acquisition-related costs.
Soon after it issued Rev. Proc. 2011-29, the IRS directed the Large Business & International (LB&I) examiners July 28 not to challenge a taxpayer’s treatment of success-based fees paid or incurred in connection with transactions described within Rev. Proc. 2011-29 for fees incurred in taxable years ended before April 8, 2011—provided that the taxpayer’s original return position to capitalize such fees consistent with the safe harbor amount described in Rev. Proc. 2011-29.
Tax Treatment of Transaction Related Costs
Treasury Regulation Sec. 1.263(a)-5 (the Transaction Cost Regulations), generally requires a taxpayer to capitalize costs incurred to investigate or otherwise pursue a variety of corporate transactions, including certain stock acquisitions, asset acquisitions, reorganizations, IPOs and borrowings.
One exception: A taxpayer is not required to capitalize all costs incurred to investigate or pursue certain acquisitive transactions, generally including taxable asset acquisitions of a trade or business, certain taxable stock acquisitions and certain tax-free reorganizations (defined to be covered transactions).
This exception requires a taxpayer to capitalize costs incurred to investigate or otherwise pursue a covered transaction only if the fees relate to activities performed on or after the “bright line date,” or if such fees are for certain “inherently facilitative” activities, regardless of when they occur.
Put another way, the Transaction Cost Regulations don’t require capitalization for fees and costs incurred before the bright line date and are for non-inherently facilitative activities.
The Transaction Cost Regulations generally define the bright line date as the earlier of the date that the parties enter into a letter of intent, exclusivity or similar arrangement, or the date that a taxpayer’s board of directors authorizes the material terms of the deal.
The Transaction Cost Regulations define inherently facilitative activities to be:
* Securing a fairness opinion
* Structuring the transaction
* Preparing and reviewing the documents that effectuate the transaction (e.g., purchase agreement)
* Obtaining shareholder approval
* Obtaining regulatory approval
* Conveying property
Because the Transaction Cost Regulations do not require a taxpayer undertaking a covered transaction to capitalize amounts incurred for non-inherently facilitative activities performed before the bright line date, a taxpayer must analyze whether such costs are deductible or amortizable under IRC secs. 162 or 195.
To take advantage of this exception to the general rule of capitalization, a taxpayer undertaking a covered transaction must be able to allocate a portion of its fees to non-inherently facilitative activities performed before the bright line date. While some service providers (e.g., law firms) may make this allocation easier by keeping detailed time records, allocations for service providers that charge on a success-based fee basis, such as investment bankers, are more difficult because they tend not to keep time-based records.
To allocate success-based fees prior to Rev. Proc. 2011-29, a taxpayer generally would obtain an allocation letter from the service provider and assemble other documentation corroborating the provider’s activities performed for the taxpayer. Typical documentation includes reports produced by the service provider (e.g., a confidential information memorandum), board presentations (e.g., made by the service provider or referencing the service provider’s work), meeting records, emails and other documents that describe the nature and timing of services performed by the provider.
Supporting this allocation is even more critical in the case of success-based fees because the Transaction Cost Regulations have a substantive documentation requirement that requires a taxpayer to capitalize success-based fees unless it assembles certain documentation and does so before the due date of its return.
The Transaction Cost Regulations give some vague guidelines regarding the sufficiency of the documentation under this rule, requiring that the documentation consist of “supporting records” that are more than “merely an allocation” of time. The regulations require the documentation to identify the activities performed by the service provider, the fee amount (or percentage of time) allocable to each of the activities performed and the amount of fee (or percentage of time) allocable to activities performed before and after the bright line date. There has always been some uncertainty regarding the nature and sufficiency of the documentation required by this rule.
Summary of the Procedure & Directive
Rev. Proc. 2011-29 addresses the uncertainty of the substantive documentation requirement by permitting a taxpayer to elect to treat 70 percent of its success-based fees for a covered transaction as an amount that does not facilitate the covered transaction. The remaining 30 percent must be capitalized. This election is in lieu of the substantive documentation requirement for success-based fees described above.
A taxpayer makes this election on a transaction-by-transaction basis and must attach a statement to the original federal income tax return for the taxable year the success-based fee is paid or incurred. The statement must affirm that the taxpayer is electing the safe harbor, identify the transaction and state the success-based fee amounts that are deducted and capitalized.
The election is irrevocable and only applies to the transaction for which the election is made. Rev. Proc. 2011-29 states that an election does not constitute a change in method of accounting, hence a Sec. 481(a) adjustment is not permitted or required.
The IRS’ July 28 directive (LB&I 04-0511-012) states that Large Business & International examiners should not challenge a taxpayer’s treatment of success-based fees paid or incurred in a transaction described in Treas. Reg. Sec. 1.263(a)-5(e)(3) in taxable years ended before April 8, 2011, if the taxpayer’s original return position is consistent with Rev. Proc. 2011-29. For such fees in taxable years ended before April 8, 2011, if a taxpayer capitalizes at least 30 percent on its tax return, IRS examiners are directed not to challenge the allocation. LB&I 04-0511-012 applies only to transaction related costs paid or incurred by either an acquiring or target corporation in a covered transaction.
LB&I 04-0511-012 does not eliminate the need for documentation to substantiate the allocation of success-based fees incurred before Rev. Proc. 2011-29 is effective. Such documentation must be in place before the date the tax return is filed. Also, LB&I 04-0511-012 does not relate to attorney, accountant or other fees that are not success-based.
While Rev. Proc. 2011-29 and LB&I 04-0511-012 are taxpayer favorable, they do not resolve all issues regarding a taxpayer’s treatment of transaction costs. Consider:
Because Rev. Proc. 2011-29 and LB&I 04-0511-012 only address success-based fees, it is still necessary to analyze costs that are not success based, such as attorney and other non-investment banker adviser fees. Also, if an investment banker fee has non-success-based components (e.g., fairness opinion fees, milestone payments) and success-based components, Rev. Proc. 2011-29 and LB&I 04-0511-012 only apply to the success-based component. Because, depending on the case, such a bifurcation of the fee can have significant positive or negative effects that are beyond the scope of this article, a taxpayer should consider the effect of such a bifurcation when it negotiates its engagement letter with its investment banker.
While Rev. Proc. 2011-29 requires an electing taxpayer to capitalize 30 percent of its success-based fees, it does not describe the treatment of the remaining 70 percent. Accordingly, it is necessary to determine whether that 70 percent is deductible under IRC Sec. 162, amortizable over 15 years under IRC Sec. 195 or treated in another manner. Also, it may be necessary to allocate within the 70 percent portion if it consists of more than one type of service. For example, if an investment banker undertook services regarding the issuance of debt in addition to its pre-bright line date investigatory services, although it is not clear, the 70 percent portion may be allocated between borrowing services and investigatory services.
Rev. Proc. 2011-29 and LB&I 04-0511-012 do not address which entity is entitled to potential tax benefits for transaction costs when one entity incurs fees “on behalf of” a related entity. For example, if a U.S. corporation incurs fees on behalf of its non-U.S. subsidiary that undertakes the acquisition, determining whether such costs are incurred by the U.S. parent or the foreign subsidiary can have significant federal tax consequences.
Depending on the transaction’s timeline, it may be the case that more than 70 percent of a taxpayer’s fees were for pre-bright line date non-inherently facilitative services. Accordingly, before making the election under Rev. Proc. 2011-29, a taxpayer should undertake preliminary inquiries to determine whether its facts could yield a tax result more favorable than that provided by the revenue procedure. A taxpayer must weigh the risk of a challenge to the higher deduction against the certainty of Rev. Proc. 2011-29’s 70-30 allocation.
Effective Date Issues
Rev. Proc. 2011-29 applies for success-based fees incurred for taxable years ending on or after April 8, 2011. This may give different effective date results for the acquiring entity and the target. For example, if the target and acquiring corporations are on a calendar taxable year and the acquiring corporation is part of a federal consolidated group, the acquiring corporation’s 100 percent acquisition of the shares of the target for cash generally would require the target to close its taxable year at the end of the day on which the acquisition closes. The acquiring corporation’s taxable year should not close before its normal year-end.
For example, if a calendar year acquiring corporation acquired all of the stock of the target March 1, 2011, the target’s year would have closed at the end of March 1, while the acquiring corporation’s year would not close until Dec. 31. Therefore, under these facts, the target would not be able to elect under Rev. Proc. 2011-29 because the March 1 transaction occurred in a year that closed prior to April 8. On the other hand, the acquiring corporation would be able to make an election for its costs because the March 1 transaction occurred in a year that will end after April 8.
If, however, the target timely obtained documentation that 70 percent of the success-based fee it incurred was not required to be capitalized under the Transaction Cost Regulations, the target could use that information and analyze the potential deductibility of 70 percent of such success-based fees for its tax return for the taxable year ended March 1, 2011. Under the Directive, the IRS should not challenge the allocation.
Jeffrey M. Hurok is a managing director, mergers & acquisitions, tax services, with KPMG LLP in Los Angeles. 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. This article represents the views of the author and does not necessarily represent the views or professional advice of KPMG LLP. John Geracimos, managing director, tax, in KPMG’s Washington National Tax practice, contributed to this article.