It is a basic principle of M&A taxation that the more a seller pays in taxes on the sale of its business, the lower will be the economic gain realized on the sale; similarly, the more slowly that a buyer recovers the costs incurred in acquiring a business, the lower will be the return on its investment.
In general, these principles are most often considered at the inception of an M&A transaction – specifically, when the decision is made to structure the deal so as to acquire a cost basis in the seller’s assets – and are manifested in the allocation of the acquisition consideration among the assets comprising the target business.
However, there is another economic element in every transaction that needs to be considered, but that is often overlooked until after the transaction has been completed and the parties are preparing the tax returns on which the tax consequences of the transaction are to be reported; specifically, the tax treatment of the various costs that are incurred by the buyer and the seller in investigating the acquisition or disposition of a business, in conducting the associated due diligence, in preparing the necessary purchase and sale agreements and related documents, and in completing the transaction.
Where these costs may be deducted, they generate an immediate tax benefit for the party that incurred them by offsetting the party’s operating income, thereby reducing the economic cost of the transaction.
Where the costs must be capitalized – i.e., added to the basis of the property being transferred or acquired, as the case may be – they may reduce the amount of capital gain realized by the seller or, in the case of the buyer, they may be recovered over the applicable recovery period.
A Successful Sale
Taxpayer engaged Investment Banker (“IB”) to explore a possible sale of Taxpayer and to identify potential buyers. The engagement letter provided that Taxpayer would pay IB a fee, determined as a percentage of the total transaction consideration, upon successful closing of the transaction (“success-based fee”).
IB’s fee was not based on an hourly rate, but was based on a number of factors, including IB’s experience. IB identified and vetted a number of potential buyers, and ultimately recommended one buyer to Taxpayer’s board of directors, which approved the buyer. IB then performed other services until the closing of the transaction. With the closing of the transaction, Taxpayer owed IB the success-based fee for its services.
After the closing, Taxpayer requested that IB estimate the amount of time IB spent on various activities relating to the transaction. Taxpayer advised IB that the day on which Taxpayer’s board of directors approved the transaction was the “bright line date.”
In response, IB sent Taxpayer a two-page letter stating that IB did not keep time records, and that its fee was not based on an hourly rate. IB stated that it could not provide meaningful estimates based on the amount of time spent on certain aspects of the transaction because it did not keep time records. IB also stated that, after talking with members of its acquisition team, it could approximate percentages of time spent on various activities; however, IB did not identify, or provide contact information for, the individuals who were consulted.
In its letter, IB estimated that approximately: 92% of its time was dedicated to identifying a buyer; 2% to drafting a fairness opinion; 4% to reviewing drafts of the acquisition agreement; and 2% to performing services after the identified bright line date. Significantly, IB’s letter included a caveat stating that the percentages were merely estimates and should not be relied on by Taxpayer.
On its tax return for the tax year in which the sale occurred, and based on IB’s letter, Taxpayer deducted 92% of the success-based fee; i.e., the time described in the letter as having been dedicated to pre-bright line date activities.
The IRS examined Taxpayer’s return, and requested support for the deduction claimed. In response, Taxpayer provided IB’s two-page letter.
The CC was consulted on whether Taxpayer had satisfied the documentation requirements (described below) by providing the letter from IB estimating the percentage of time spent on so-called “facilitative” and “non-facilitative” activities where the letter included the caveat that the letter should not be relied on by Taxpayer as IB did not keep time records.
The CC determined that Taxpayer could not satisfy the documentation requirements.
The Code provides that there shall be allowed as a deduction, in determining a taxpayer’s taxable income for a tax year, all the ordinary and necessary expenses paid or incurred by the taxpayer during the year in carrying on any trade or business.
However, the Code and the Regulations promulgated thereunder also provide that a taxpayer must capitalize an amount paid to facilitate an acquisition of a trade or business. An amount is paid to “facilitate” a transaction if the amount is paid in the process of investigating or otherwise pursuing the transaction. Whether an amount is paid in the process of investigating or otherwise pursuing the transaction is determined based on all of the facts and circumstances.
The Regulations provide that – except for certain “inherently facilitative” costs – an amount paid by the taxpayer in the process of investigating or otherwise pursuing a “covered transaction” facilitates the transaction (and must be capitalized) only if the amount paid relates to activities performed on or after the earlier of:
- the date a letter of intent or similar communication is executed, or
- the date on which the material terms of the transaction are authorized or approved by the taxpayer’s board of directors (the so-called “bright line date”).
The term “covered transaction” includes, among other things, the taxable acquisition of assets that constitute a trade or business.
Amounts that are treated as inherently facilitative, regardless of when they are incurred, include, among others:
- Securing an appraisal, formal written evaluation, or fairness opinion related to the transaction;
- Structuring the transaction, including negotiating the structure of the transaction and obtaining tax advice on the structure of the transaction;
- Preparing and reviewing the documents that effectuate the transaction;
- Obtaining regulatory approval of the transaction;
- Obtaining shareholder approval of the transaction; or
- Conveying property between the parties to the transaction.
According to the Regulations, an amount paid that is contingent on the successful closing of a transaction is treated as an amount paid to facilitate the transaction – i.e., an amount that must be capitalized – except to the extent the taxpayer maintains sufficient documentation to establish that a portion of the fee is allocable to activities that do not facilitate the transaction (the “Documentation”).
The Documentation must be completed on or before the due date of the taxpayer’s timely filed original federal income tax return (including extensions) for the taxable year during which the transaction closes.
In addition, the Documentation “must consist of more than merely an allocation between activities that facilitate the transaction and activities that do not facilitate the transaction;” rather, it must consist of supporting records – for example, time records, itemized invoices, or other records – that identify:
- The various activities performed by the service provider;
- The amount of the fee (or percentage of time) that is allocable to each of the various activities performed;
- 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
- The name, business address, and business telephone number of the service provider.
Several years back, in recognition of the difficulty that many taxpayers faced in maintaining and producing the Documentation, the IRS provided a “safe harbor” election for allocating success-based fees paid in a covered transaction. In lieu of maintaining the Documentation, electing taxpayers may treat 70% of the success-based fees as an amount that does not facilitate the transaction – and that may be deducted – and the remaining 30% must be capitalized as an amount that facilitates the transaction.
This safe harbor was provided, in part, to incentivize taxpayers to make the election rather than attempt to determine the type and extent of documentation required to establish that a portion of a success-based fee is allocable to activities that do not facilitate a covered transaction.
In the present case, Taxpayer did not make the safe harbor election. Therefore, Taxpayer had to provide the Documentation, or no portion of the success-based fee would be deductible.
The CC found that IB’s two-page letter was merely an allocation between activities that facilitated and did not facilitate the transaction, which the Regulations specifically forbid. Because the letter was merely an allocation, it could not satisfy the Documentation requirements. Accordingly, Taxpayer had to capitalize 100% of the success-based fee.
Taxpayer attempted to provide time estimates from IB even though Taxpayer knew that IB did not keep time records. The Documentation requirements do not require a taxpayer’s supporting records to identify the percentage of time that is allocable to each activity, but they do require the supporting records to identify the amount of the fee that is allocable to each activity.
The estimated allocation letter from IB had no effect, and without other documentation, Taxpayer’s deduction was denied.
Interestingly, it wasn’t until after the closing that Taxpayer asked IB to provide the documentary support that may have allowed the success-based fee to escape treatment as a facilitative cost that had to be capitalized.
Taxpayers and their advisers have to be aware that the treatment of M&A transaction costs may have a significant impact upon the net economic cost or gain of a “covered transaction” like the one described in the above ruling.
They also have to know that the necessary documentation or record should be created contemporaneously, as the transaction unfolds, not after the deal.
The most puzzling aspect of the situation described in the ruling, however, is Taxpayer’s failure to make the safe harbor election to treat 70% of the success-based fee paid to IB as a non-facilitative deal cost that Taxpayer could have deducted without question. Pigs get fat, hogs get slaughtered?