IRS Expands and Simplifies Deductibility of Certain Success-Based Transaction Fees (Primarily Investment Banking Fees)
Date: April 29, 2011
For years, the deductibility of success-based investment banking fees has been the source of controversy both with respect to (A) the proper documentation and (B) the IRS position that the portion of the fee allocated to period following the execution of a nonbinding letter of intent is not deductible. Extended discussions occurred with investment banks to have them provide detail as to the level of services provided before and after a certain date without a favorable resolution in many instances. The IRS adopted a more lenient position for transactions prior to 2004 but subsequent regulations increased the documentation requirement.
On April 8, the IRS issued Rev. Proc. 2011-29 in which it reversed its position and now allows a large portion of success-based fees to be deductible without the need for any particular documentation. The following Q&As discuss the changes made by the new IRS Revenue Procedure.
1. What portion of success-based fees are deductible pursuant to the Rev. Proc.?
70%. This can mean an automatic large tax benefit for certain deals that closed earlier this year.
2. Does the Rev. Proc. apply to all transaction fees?
No. The Rev. Proc. applies only to a percentage of certain "success-based fees" that relate to stock acquisitions, business asset acquisitions or acquisitive tax-free reorganizations. Success-based fees that relate to stock issuances, Section 355 spin-off transactions or certain purchases of real estate (possibly unimproved land) are not covered by the Rev. Proc. Success-based fees are those amounts that are contingent on the closing of the transaction.
In contrast to the application of the new Rev. Proc., LMSB issued a Directive in 2005 with respect to pre-2004 tax years that allowed the IRS to accept the deductibility of a certain percentage of all transaction costs. The prior LMSB Directive used a lower percentage (35% - 50%) as the deductible portion but such percentage applied to all transactional fees. The new Rev. Proc. allows a greater percentage of fees to be deductible but is limited to success-based fees.
3. Is the new Rev. Proc. available for all success-based fees?
No. The success-based fee must be incurred in connection with an acquisition transaction that expands an existing business. If the success-based fee is incurred with an acquisition that is considered to be entering a new business, then the fees would continue to be treated as "start-up" expenses amortized over 15 years pursuant to Section 195.
4. So again, what does the Rev. Proc. provide?
The Rev. Proc. allows an automatic 70% deduction for success-based fees that relate to stock acquisitions, business asset acquisitions or acquisitive tax-free reorganizations that expand the acquiring corporation's existing business. This deduction is available to the success-based fees incurred by both the acquiring and the acquired corporation in a stock acquisition transaction. The largest (and in some cases the only) success-based fees are the investment banking fees, and the focus of this issue has been on such expenses.
5. What is the tax treatment of transaction fees that are not success-based but that relate to expanding an existing business?
The current rules continue to apply for those fees that are not subject to the Rev. Proc. This means that the current bright line date test (referenced in 6 below) and the necessary documentation reflecting amounts incurred prior to and after the bright line date continue to apply. These transaction fees can be divided into four categories:
a. With respect to non success-based fees incurred for (i) fairness opinions, (ii) structuring the transaction, (iii) tax advice, (iv) preparing and reviewing the necessary documentation, (v) preparing, reviewing and obtaining regulatory approval, and (vi) obtaining shareholder approval, such fees continue to be nondeductible in all events pursuant to the existing regulations. These fees are referred to as "inherently facilitative" fees. Under current rules, inherently facilitative fees are capitalized.
b. With respect to non success-based due diligence expenses (other than "inherently facilitative" expenses) incurred prior to the bright line date referred in (6) below, such amounts are immediately deductible. For situations where letters of intent have been executed, the investigatory expenses deemed incurred prior to the bright line date might not be relatively large.
c. With respect to non success-based due diligence expenses attributable to the period after the bright line date, such amounts are capitalized.
d. Certain other fees have to be reviewed separately and could be immediately deductible even though they are connected to a transaction, such as employee compensation and integration fees.
If payment of any portion of the fees described in (a)-(d) above (regardless of whether payable to an investment bank, a law firm or some other third party) are conditioned on the acquisition closing, then such expenses would also be eligible for deductibility pursuant to the Rev. Proc. This is another favorable change. This change could encourage alternative fee arrangements to allow for a portion of a success-based amount to be deductible, which might otherwise be considered inherently facilitative and not deductible.
6. Do acquiring and target corporations still have to be concerned with the current rule (and the related documentation requirement) that success-based fees are deductible only if they are attributable to the period before the execution of a letter of intent, exclusivity agreement or similar written communication or, if there is no such agreement, the date that the material terms of the arrangement are authorized by the parties (the so-called "bright line" date)?
No, if the taxpayer elects the safe harbor available under the new Rev. Proc. If the new safe harbor is elected, 70% of the success based fees would be deductible, regardless of whether such fee is attributable to the period before or after a letter of intent. This is a major change.
Most deals require a letter of intent early in the discussion process and such LOI is non-binding with an established price that is subject to change. This has meant that a substantial portion of the investment banking fees may have been nondeductible, particularly in situations involving the acquisition of privately-held corporations where the relevant information regarding the target's operations is not available. The Rev. Proc. bypasses this requirement for success-based fees.
7. Are there situations where the approach requiring specific documentation of time spent by the investment banking firm before versus after the relevant date yields a better result?
Yes. In situations where there is no letter of intent or exclusivity agreement and the bright line dates arises when the respective boards of directors approve the purchase agreement, the current regulations could yield a larger tax benefit. In these situations, the current regulations state that only the portion of the fee allocated to the before board authorization is deductible. The remaining work done by the investment banks between the signing of the purchase agreement and the closing might be limited. In such instances, it is possible that the work deemed performed by the investment bank prior to such board action date exceeds 70%.
This potential benefit would require additional work by the acquiring and target corporation with respect to the success-based fees. The acquiring corporation would need to develop the necessary documentation required by the regulations to substantiate such deduction (which would not be necessary if the Rev. Proc. approach is elected). The IRS has allowed the necessary documentation to be developed on behalf of the acquiring corporation with limited involvement by the investment bank. However, it has been a task. Although some acquiring corporations have obtained meaningful cooperation from investment banks in the past (and have worked with investment banks who have agreed to specific language in the engagement letter on the documentation that they would provide), such investment banks would probably be less interested in any significant level of cooperation in the future because the Rev. Proc. provides a significant benefit without their involvement. Investment banks might begin to delete certain documentation provisions that have previously been included in engagement letters.
8. How does a corporation elect the procedure available under the Rev. Proc.?
The tax return filed for the tax year that the transaction closes must include a statement that (a) identifies the transaction, (b) shows the success-based amount, (c) states that the corporation is electing the safe harbor, and (d) reflects the amount that is deductible versus capitalized. Once made, an election is irrevocable.
9. Can an election under the new Rev. Proc be made following the filing of the corporation's tax return for the year that the transaction closes?
Yes, but possibly with limitations. The Rev. Proc. (as do the regulations) state that the method originally selected on the tax return to determine the amount of the deductible success-based fee is a method of accounting, but the Rev. Proc. goes on to say that an election under the Rev. Proc. is not a change in a method of accounting. Accordingly, this would mean that an election could be made after the tax return has been filed.
The procedure available to file a late election is provided under the 9100 relief rules. For taxpayers who were unaware that an election was available (or otherwise satisfy the 9100 requirements), relief might be available. The IRS has granted 9100 relief under the existing regulations in the context of preparing documentation after the due date for filing the corporation's tax return, when the facts warrant an extension.
10. If an acquiring corporation claims a more than 70% deduction and the IRS challenges the documentation relating to the success-based fee, would the taxpayer nonetheless be able to deduct the 70% amount under the Rev. Proc.?
This remains to be seen.
The normal approach to make a late election would be the 9100 relief provisions. However, the 9100 relief provisions would seem unavailable when a taxpayer is aware of the election procedure and consciously uses the documentation procedure available under the regulations to claim a higher deduction, which is later challenged.
At issue is whether LB&I/LMSB will develop a procedure (as it did in 2005) that would allow IRS agents to accept the Rev. Proc. approach as a fall back in situations where there has been a good faith effort to comply with the documentation requirement under the regulations.
11. What is the effective date of the Rev. Proc. and how do the regulation apply to tax years that closed prior to April 2011?
Transactions within Effective Date
The Rev. Proc. is applicable only to tax years ending on or after April 8, 2011. Friday, April 8 was the date that the Rev. Proc. was issued. Success-based fees incurred by a calendar year acquiring corporation for transactions that closed at any time during 2011 would be eligible. Success-based fees incurred by an acquiring corporation on a fiscal year that ends on or after April 8 would be eligible for transactions that closed at any time during such fiscal year, even if the closing was on or prior to December 31, 2010.
Transactions Outside Effective Date
The Rev. Proc. is not applicable to certain success-based fees already incurred where the federal income tax return that include the transaction closing date has not yet been filed. Success-based fees incurred by a calendar year acquiring corporation for transactions that closed during 2010 and prior years are not eligible. Success-based fees incurred by a target corporation where the stock was acquired prior to April 8 by an acquiring corporation filing a consolidated tax return would not be eligible because the tax year of the target corporation ends on the closing date.
It will also be interesting whether LB&I/LMSB develops guidance that would encourage IRS field agents to accept deductible amounts that fit within the Rev. Proc. For those corporations that have not filed their tax returns, this is a conundrum of whether to develop the necessary documentation currently required by the regulations or wait for further relief.
12. For acquiring corporations engaged in transactions that closed during the first quarter of 2011, should 10-Q filings have reflected the tax benefit available under the Rev. Proc. or the lesser amount that might have been available under the regulations in those situations where a letter of intent was executed early in the process?
The Rev. Proc. is a change in administrative practice, and it would seem that the 10-Q should reflect only the amount that could have been deductible under the approach required by the regulations as of the end of the quarter prior to the issuance of the Rev. Proc.
13. What happens to the portion of the transaction costs required to be capitalized?
The structure of the acquisition transaction will govern the tax treatment of these costs.
If the transaction is a stock acquisition (including a reverse cash merger, reverse stock merger and a stock-for-stock exchange), the acquiring corporation's capitalized costs would be added to the tax basis of the shares and would not be amortized.
If the transaction is a cash asset acquisition (including a cash forward merger or a Section 338(h)(10) transaction), the acquiring corporation's capitalized costs would be added to the tax basis of the acquired assets and should be amortized, as appropriate.
If the transaction is a tax-free asset acquisition (including an all-stock forward merger), the regulations have reserved (for a long time) on the question of the acquiring corporation's capitalized costs. Discussions can develop on whether such costs should be added to the tax basis of the acquired assets and be amortized over the lives of such assets.
With respect to the target/acquired corporation's capitalized costs under any form of transaction, the acquired corporation's capitalized costs are not amortized in accordance with the Indopco decision, except that if the acquired corporation is selling assets in a cash deal, the capitalized costs would, in effect, reduce the gain (or increase the loss) on the sale of such assets.
Prospect for Additional Guidance
For costs that are required to be capitalized and not amortizable, we continue to wait for IRS guidance that would allow amortization of such amount over a fixed period (e.g., 15 years). This issue had been part of the project that led to the new Rev. Proc. but has been separated, and there is no timetable as to when any such additional guidance might be issued. Fees in this category include non success-based fees that are "inherently facilitative" (described in 5a, above), non-success based fees that are attributable to the period after the bright line date and the 30% non-deductible success-based fees under the Rev. Proc.
14. More Interesting Questions
An election made under the Rev. Proc. must apply to all success-based costs relating to the transaction. Hopefully, the Rev. Proc. is not intended to include success-based fees that would otherwise be deductible in full under the current regulations. For example, if the acquiring corporation has bonus arrangements dependent on a successful closing of a transaction, would such compensation expense be swept into the Rev. Proc? Meaning that if an election to use the Rev. Proc. is made, only 70% of such fees would be deductible. The answer should be no, but guidance to prevent this issue from being raised on audit or as part of the FIN 48 analysis would be useful.
Acquired Versus Acquiring Corporation Elections
The acquiring and the acquired corporation should be able to separately decide whether to make the election available by the Rev. Proc. The election applies to the "taxpayer." An acquired corporation that becomes a member of a consolidated group can make the election on its final return that ends on the closing date and the acquiring corporation would make its election on the tax return that includes the acquisition date. Even though the acquiring corporation might be responsible for filing the acquired corporation's final return, each such corporation should be able to separately decide whether to make the election.
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