The Internal Revenue Code, specifically Section 162(a), states that a deduction is allowed for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. That may seem simple enough, but corporate taxpayers must consider how a related rule — Regulation Section 1.263(a)-5(a) — affects the deduction.
Ultimately, the regulation says that a taxpayer must capitalize an amount paid to facilitate the acquisition of assets that constitute a trade or business, whether the taxpayer is the target corporation or the acquiring corporation. However, the regulation moves through five provisions to help taxpayers identify the proper treatment of the expense.
For example, one provision1 states that the amount is considered “paid to facilitate” the transaction if it is doled out in the process of investigating or otherwise pursuing the transaction. The regulation further explains2 that an amount paid in the process of investigating or otherwise pursuing a covered transaction facilitates the transaction only if the following occurs: the payment relates to activities performed on or after the earlier of (1) the date on which a letter of intent (or similar written communication) is executed or (2) the date on which the material terms of the transaction are approved by the taxpayer’s board of directors.
There’s more. The regulation provides a list of costs3 that are “inherently facilitative,” meaning that these costs must be capitalized regardless of whether they relate to activities performed on one of the two date options described above.4
What’s more, the regulation notes that a covered transaction is defined in Regulation Section 1.263(a)-5(e)(3) and includes a taxable acquisition of assets that constitute a trade or business, and certain reorganizations. Finally, the regulation5 points out that an amount paid that is contingent on the successful closing of a transaction (a “success-based” fee) is an amount paid to facilitate the transaction except to the extent the taxpayer maintains sufficient documentation to establish that a portion of the fee can be allocated to activities that do not facilitate the transaction.
The Internal Revenue Service applied this litany of rules to a typical example case, described below. In the example, the IRS reached a conclusion that spreadsheets used to back up the deal analysis represented sufficient documentation to allow a company to classify a portion of the success-based fees paid out as deductions.
Here are the details of the example case:
• In February, Alpha Inc., a domestic corporation, decided to explore strategic alternatives, and as a result hired Corporation X and Beta Investment Bank to provide services to help identify a possible sale, merger, or partnership opportunities.
• On February 15, Alpha entered into a “services agreement” with Corporation X. Under the terms of the agreement, Alpha was obligated to pay a lump-sum contingent fee to Corporation X if either Alpha entered into a purchase and sale agreement or if a sale of all, or substantially all, of Alpha’s stock occurred during the time frame specified in the services agreement.
• On February 20, Alpha entered into an engagement letter with Beta Bank. Under the terms of the engagement letter, Alpha was obligated to pay a nonrefundable retainer, as well as a contingent fee, in the event a sale of Alpha was consummated during the time frame specified in the engagement letter.
• On April 1, Yale Inc. submitted an offer to purchase Alpha’s stock. On that same date, Alpha’s board of directors approved the proposed form, terms, and provisions of the stock-purchase agreement. A formal written “indication of interest” was never received from Yale Inc. In addition, the parties did not execute a letter of intent, exclusivity agreement, or similar written communication (other than a confidentiality agreement). Thus, April 1 was the date on which the material terms of the transaction were approved by Alpha’s board.
• On May 15, Alpha and Yale entered into a stock-purchase agreement. The acquisition was closed on June 1. Corporation X’s invoice for its contingent fee was dated July 15, while Beta Bank’s invoice for its contingent fee was dated July 30.
• Alpha then engaged Omega Accounting to conduct a study of the transaction costs incurred based on services performed by Corporation X and Beta Bank through the date of the sale. Mr. Olleander of Omega Accounting drafted a description of activities performed in two general spreadsheets: one for Corporation X and one for Beta Bank.
• Then an investment banker from Corporation X and an employee from Beta Bank filled out the general spreadsheets with a percent of time spent on each activity category and sent the completed spreadsheets to Omega Accounting on August 15. The time sheet included the percent of time spent before and after April 1 (when Yale purchased Alpha’s stock). The spreadsheets were used by Alpha to determine the portion of the success-based fees that were deductible and the portion that were required to be capitalized.
In the example case, it was undisputed that Alpha was acquired in a transaction to which Regulation Section 1.263(a)-5(a) applies. Therefore, Alpha is required to capitalize the costs incurred to facilitate the transaction. Generally, in the case of a success-based fee, the documentation must consist of more than merely an allocation between activities that facilitate the transaction and activities that do not facilitate the transaction. What’s more, those activities must consist of supporting records (for example, time records, itemized invoices, or other records) that identify the activities performed, the fee allocable to those activities, the date of performance, and the service provider. Moreover, the documentation must be completed on or before the due date of the taxpayer’s (Alpha’s) timely filed tax return — including extensions — for the taxable year during which the transaction closes.
Again, in the instant case, Alpha used the allocation provided in the general spreadsheets developed by Omega Accounting. The issue was whether the general spreadsheets developed by Omega, in conjunction with employees of both Corporation X and Beta Bank, qualified as other records. Indeed, the existence of other records can function to adequately distinguish the costs that facilitate the transaction from those that do not. In fact, last year in a Technical Advice Memorandum, the IRS ruled that the spreadsheets constituted other records.6
In reaching its conclusion, the IRS noted that, under Regulation Section 1.263(a)-5(f), records other than time records or itemized invoices can qualify as “other records” for purposes of substantiating the nonfacilitative portion of a success-based fee. Moreover, the term other records is not explicitly defined in the regulations; as a result, there are no limitations on the type or source of documents that can qualify. In fact, the IRS ruled that any document can serve to establish the deductible portion of a success-based fee. This is true, said the ruling, even where, as in the example case, the document was not directly prepared by the service provider.
Under the facts of this case, Corporation X and Beta Bank clearly engaged in activities that were nonfacilitative, and clearly engaged in those activities before the date on which the material terms of the transaction were approved by Alpha’s board. Most notably, the IRS indicated that Regulation Section 1.263(a)-5(f) should not be read in a manner that would automatically preclude the deduction of Alpha’s nonfacilitative costs simply because the company is unable to provide time records or itemized invoices.
What’s more, the ruling concluded that the spreadsheets prepared by Omega Accounting (in conjunction with employees of Corporation X and Beta Bank) qualify as other records. Therefore, the IRS decreed that its auditor must take the spreadsheet into account (although it did not specify the probative weight to be accorded these other records) in determining whether Alpha maintained sufficient documentation to establish that a portion of the success-based fees remitted to Corporation X and Beta Bank are properly allocated to activities that do not facilitate the transaction.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 Regulation Section 1.263(a)-5(b).
2 Regulation Section 1.263(a)-5(e)(1).
3 Regulation Section 1.263(a)-5(e)(2).
4 An amount is inherently facilitative if it is paid for (i) securing an appraisal or fairness opinion related to the transaction; (ii) structuring the transaction (including obtaining taxation advice with respect to the structure of the transaction); (iii) preparing and reviewing the documents that effectuate the transaction (for example, a merger agreement or purchase agreement);
(iv) obtaining regulatory approval of the transaction including preparing and reviewing regulatory filings; (v) obtaining shareholder approval of the transaction (for example, proxy costs, solicitation costs, and costs to promote the transaction to shareholders); or (vi) conveying property between the parties to the transaction (for example, transfer taxes and title registration costs).
5 Regulation Section 1.263(a)-5(f).
6 See LTR 201002036, September 21, 2009.