In a Practice Unit, IRS has set out the best practice recommendations for examining a taxpayer’s treatment of corporate transaction costs, i.e., costs that a taxpayer may incur, such as legal, accounting, consulting, or investment advisory service fees, when executing a business transaction. If the cost facilitates a transaction described in Reg. § 1.263(a)-5(a) (e.g., acquiring or selling a trade or business, or changing a company’s capital structure), the taxpayer must capitalize the cost.
Background. Reg. § 1.263(a)-5 describes whether a cost incurred facilitates a transaction listed in Reg. § 1.263(a)-5(a) and how the costs that facilitate some of those transactions are treated when capitalized. Case law and other published guidance interpret the application of the rules under Reg. § 1.263(a)-5 and provide guidance where Reg. § 1.263(a)-5(a) does not.
Reg. § 1.263(a)-5(a) requires a taxpayer to capitalize amounts that facilitate:
…acquiring assets that constitute a trade or business;
…acquiring an ownership interest in a business entity if, immediately after the acquisition, the taxpayer and the business entity are related within the meaning of Code Sec. 267(b) or Code Sec. 707(b);
…acquiring an ownership interest in the taxpayer;
…restructuring, recapitalizing or reorganizing the capital structure of a business entity, including a reorganization described in Code Sec. 368 and a stock distribution described in Code Sec. 355;
…contributing property to a corporation in exchange for stock, as described in Code Sec. 351, or to a partnership in exchange for a partnership interest, as described in Code Sec. 721;
…forming or organizing a disregarded entity;
…borrowing money; and
…writing an option.
In addition, other sections of the Code Sec. 263(a) regs (which are not discussed in the Practice Unit) address facilitative costs.
Examining a transaction cost issue. The Practice Unit discusses the three-step process for analyzing a transaction costs issue: (1) determine whether the taxpayer is the proper legal entity to take the transaction costs into account for tax purposes; (2) determine whether the costs facilitate the transaction; and (3) determine how the taxpayer should treat facilitative costs it must capitalize.
The proper legal entity. Many of the transactions listed under Reg. § 1.263(a)-5(a) involve multiple parties. Each party can incur transaction costs. Generally, the legal entity that incurs a cost takes the cost into account for tax purposes, either as a deduction, or as a capital expenditure; however, there is an exception for costs that facilitate a borrowing, as defined in Reg. § 1.263(a)-5(a)(9). The party to the transaction that pays a cost is not always the legal entity that incurs the cost. An amount considered to have been paid by a party to the transaction includes an amount paid on its behalf by another party to the transaction. (Reg. § 1.263(a)-5(k))
If the taxpayer is not the proper legal entity to take the transaction costs into account, the amount (if paid by the taxpayer) may be a capital contribution, a distribution, or a loan. If the taxpayer is the proper legal entity to take the transaction costs into account, the next step is to determine whether the costs facilitate the transaction and must be capitalized.
In order to be treated as incurring a cost paid on its behalf by another entity, a party must have benefited from the services for which the payment was made. This requirement prevents the benefit of an expenditure from being “assigned” to a specific party simply by having that party pay the cost. If a taxpayer benefits from services paid for by another party and does not reimburse the paying party, depending on their relationship, the amount paid is treated as either a capital contribution or a distribution to the taxpayer. The taxpayer is then treated as using the funds to pay for the services.
The Practice Unit advised that determining which legal entity should take a cost into account requires an analysis of the relevant facts and circumstances. Questions to consider include: What service was provided? On whose behalf was the service rendered? To whom was the service rendered? To whom did the service provider report? Who directly benefited from the service? Who incurred the economic burden for the service? Who paid for the service? The following may be helpful in determining which legal entity incurred the costs: documentation, such as engagement letters, contracts or agreements describing the services to be provided; invoices showing to which entity the service provider billed the fees; written communication between the service provider, the taxpayer and other parties on the work performed (e.g., letters, memos, electronic mail); and minutes of meetings on the work performed.
Costs that facilitate a borrowing are generally treated as incurred by the borrower. Where the loan proceeds and repayment obligation are assumed (or deemed assumed) by a successor of the borrower, the successor is generally allowed to amortize the capitalized costs over the loan term. (Reg. § 1.446-5)
Facilitative costs. A taxpayer must capitalize a cost that facilitates a transaction described in Reg. § 1.263(a)-5(a). Whether a cost facilitates such a transaction is based on all the facts and circumstances. The cost must be paid to investigate or otherwise pursue the transaction. The fact that a cost would (or would not) have been paid but for the transaction is relevant, but does not determine whether the amount facilitates the transaction. (Reg. § 1.263(a)-5(b)(1)) Examples of costs to investigate or otherwise pursue a transaction include (but are not limited to) a fee paid to: an appraiser to determine the value or purchase price of acquired assets which constitute a trade or business; an attorney to assist the taxpayer in executing an initial public offering (IPO) of its stock; and an investment banker to market a bond issuance to the public.
The purchase price of corporate assets or stock is not an amount paid to investigate or otherwise pursue a transaction; therefore, is not a facilitative cost. (Reg. § 1.263(a)-5(b)(1)) However, an ownership interest in a corporation is an intangible asset and an amount paid to acquire an intangible asset is capitalizable under Reg. § 1.263(a)-4. When both Reg. § 1.263(a)-5 and Reg. § 1.263(a)-4 apply to the same cost, the rules of Reg. § 1.263(a)-5 govern the treatment of the cost. (Reg. § 1.263(a)-5(b)(2)) An amount required to be capitalized by Reg. § 1.263(a)-1, Reg. § 1.263(a)-2, or Reg. § 1.263(a)-4 does not facilitate a transaction described in Reg. § 1.263(a)-5(a).
Costs resulting from the transaction costs which result from the transaction are not facilitative costs. For example, when a taxpayer executes an Initial Public Offering (IPO), it may be obligated to pay a fee to terminate a service agreement such as a management agreement—and such a payment is not incurred to investigate or otherwise pursue the IPO, does not facilitate the transaction, and is not capitalizable under Reg. § 1.263(a)-5. In addition, the cost of representation and warranty insurance, or directors’ and officers’ insurance required by the terms of the transaction agreement, does not facilitate the transaction but may be capitalizable as a cost to create the insurance contract (an intangible). (Reg. § 1.263(a)-4(d)(2)(i)(D))
Under special rules and simplifying conventions, certain costs do not facilitate a transaction described in Reg. § 1.263(a)-5(a). (Reg. § 1.263(a)-5(c) and Reg. § 1.263(a)-5(d)) For example, business integration costs are incurred to combine two or more businesses and typically include costs to relocate equipment and personnel, combine records and information systems, provide severance benefits to employees who are terminated because of the business combination, prepare financial statements for the combined entity, and reduce redundancies in the combined business operations. Business integration costs do not facilitate the transaction that resulted in the combined business.
Costs that are not facilitative and not capitalizable under Reg. § 1.263(a)-5(a) may be deductible as an ordinary or necessary expense under Code Sec. 162, or may be capitalizable under another section of the Code (e.g., a start-up cost under Code Sec. 195), or under another provision of Code Sec. 263(a) (e.g., a cost that facilitates the acquisition or creation of an intangible under Reg. § 1.263(a)-4(e)).
Covered transactions. For “covered transactions,” there are special rules to determine which costs are facilitative.” Covered transactions” include: acquiring assets that constitute a trade or business in a taxable transaction; acquiring an ownership interest in a business entity (whether the taxpayer is the acquirer or the target) in a taxable transaction if, immediately after the transaction, the acquirer and the target are related within the meaning of Code Sec. 267(b) or Code Sec. 707(b); a reorganization described in Code Sec. 368(a)(1)(A), Code Sec. 368(a)(1)(B), or Code Sec. 368(a)(1)(C); or a reorganization described in Code Sec. 368(a)(1)(D) in which stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under Code Sec. 354 or Code Sec. 356 (whether the taxpayer is the acquirer or the target). A covered transaction does not include a taxable transaction in which the taxpayer’s assets are acquired, or are deemed to be acquired in a transaction that is not structured as an asset acquisition, but is recast as an asset acquisition under applicable law (e.g., a qualified stock purchase with an Code Sec. 338 election).
If the transaction is a covered transaction, facilitative costs are determined based on the “bright-line date” and whether or not the related services are inherently facilitative. Except for inherently facilitative costs, a cost incurred for services rendered before the bright-line date to investigate or otherwise pursue the transaction does not facilitate the transaction. The bright-line date is the earlier of: the date on which representatives of the acquirer and the target execute a letter of intent, exclusivity agreement, term sheet or similar written document (other than a confidentiality agreement) reflecting the terms of the transaction, or the date on which the taxpayer’s board of directors, or its appropriate governing officials (if the taxpayer is not a corporation), authorize or approve the material terms of the transaction as agreed to by representatives of the acquirer and the target.
An “inherently facilitative” cost is an amount paid for certain types of activities (i.e., services performed) to investigate or otherwise pursue the transaction. Inherently facilitative costs must be capitalized regardless of when the related services are performed. Among the costs that are inherently facilitative are ones paid for the following activities (or similar types of activities): an appraisal, written evaluation, or fairness opinion related to the transaction; advice and assistance in structuring the transaction; advice and assistance in obtaining regulatory approval of the transaction; obtaining shareholder approval of the transaction (e.g., proxy, solicitation and promotion costs); and conveying property between the parties to the transaction (e.g., transfer taxes and title registration fees).
Success-based fees. A cost that is payable upon the successful completion of a transaction (a “success-based fee”) is presumed to facilitate the transaction and must be capitalized. A taxpayer may rebut the presumption that the cost facilitates the transaction by timely providing sufficient documentation to support allocating some or all of the cost to activities that do not facilitate the transaction. (Reg. § 1.263(a)-5(f)) Under Rev Proc 2011-29, a taxpayer that incurs success-based fees in connection with a covered transaction in tax years ending on or after Apr. 8, 2011, can elect to treat 70% of the success-based fees as not facilitating the transaction. The taxpayer must capitalize the remaining 30% of the success-based fees on its timely-filed original return (including extensions). If the taxpayer elects to apply this “safe-harbor allocation” to success-based fees, the taxpayer avoids the documentation requirements; however, the taxpayer must apply the safe-harbor allocation to the total amount of success-based fees incurred in connection with the transaction and cannot revoke the election.
Treatment of facilitative costs. Costs that are facilitative and must be capitalized under Reg. § 1.263(a)-5 may be recoverable immediately, may be recoverable over time, or may never be recoverable. The structure of the transaction and the taxpayer’s role in the transaction (e.g., acquirer or target) determine how the capitalized costs are treated. Reg. § 1.263(a)-5(g) provides guidance regarding the treatment of costs that facilitate certain types of transactions.
Costs that facilitate the following types of transactions are treated as follows:
…Taxable acquisition of assets by the taxpayer: Increases the basis of assets acquired.
…Taxable acquisition of stock by the taxpayer: Increases the basis of stock acquired.
…Taxable sale of assets by the taxpayer: Reduces the amount realized on asset sale.
…Borrowing by the taxpayer: Generally, amortized over the loan term.
Not all transactions described in Reg. § 1.263(a)-5(a) are addressed and guidance is reserved for certain types of transactions. Where the regs do not provide guidance on the treatment of costs that facilitate certain types of transactions, other authorities govern the treatment of those costs. For example, costs that facilitate a stock issuance must be capitalized. (Reg. § 1.263(a)-5(a)(8))
References: For the treatment of expenses incurred in connection with business acquisitions and reorganizations, see FTC 2d/FIN ¶L-5400 et seq.; United States Tax Reporter ¶2634.80.