In a hypothetical example, a seller (SellCo) files for Chapter 11 protection under the U.S. Bankruptcy Code. Shortly thereafter, another corporation (Alpha Corp.) files with the court an “asset purchase agreement” detailing the proposed sale of substantially all of SellCo’s assets to Alpha. The agreement states that Alpha will assume certain liabilities of SellCo and pay cash consideration “in exchange for the assets.” With the contract in place, the transaction closes.
At issue is whether Alpha’s assumption of liabilities must be capitalized to the basis of the acquired assets under the Internal Revenue Code, specifically Section 263(a), which disallows deductions for capital expenditures. In a chief counsel’s advisory, the Internal Revenue Service concluded that the assumption of liabilities had to be capitalized to the basis of the acquired assets under Section 263(a).1 Here is the rationale behind the IRS’s decision.
A buyer who purchases business assets and assumes a seller’s liabilities, either fixed or contingent, in connection with the acquisition must capitalize payments made on such liabilities.2 However, it is sometimes difficult to distinguish between contingent liabilities assumed from the seller and expenses the buyer incurs while operating the acquired business. Case law identifies a number of factors to be considered in determining whether contingent liabilities must be capitalized, such as whether:
• the liability is related to the seller’s or the purchaser’s operation of the business;
• the liability arose out of pre- or postacquisition events;
• the purchaser was aware of the liability;
• the liability was contemplated when negotiating the purchase price;
• the purchaser expressly assumed the liability; and
• the purchaser could have avoided the liability.3
Capitalization is required when the events “most crucial” to the creation of the obligation occur before the acquisition; whereas deduction is allowed when the events most crucial to the creation of the obligation occur after the acquisition. In the case explained in the chief counsel’s letter, Alpha contended that it did not have to capitalize any of the assumed liabilities. But the IRS disagreed.
The IRS noted that federal tax law looks to a seller’s amount realized as the starting point for calculating the seller’s gain or loss, and looks to a purchaser’s cost as the starting point for calculating the purchaser’s basis. Absolute symmetry between the two is not required.
Because the amount Alpha is required to capitalize under Section. 263(a) is not dependent on the amount that SellCo received from Alpha, the IRS did not agree that capitalization is precluded if SellCo received no benefit from Alpha’s assumption of liabilities. That’s because the liabilities were “economically worthless” and ultimately would have been discharged in the bankruptcy proceeding.
Regarding the contingent liabilities assumed (the fixed liabilities clearly had to be capitalized), the information provided by Alpha showed that the assumed liabilities related to SellCo’s operation of the business. The liabilities existed at the time of the asset acquisition and were incurred by SellCo. The fact that Alpha was not legally obligated to assume any of the liabilities in connection with the purchase of SellCo’s assets does not change the fact that the liabilities arose out of the preacquisition business dealings of SellCo. Indeed, although Alpha voluntarily chose to assume the liabilities as part of the acquisition, the act of volunteering does not transform the preacquisition liabilities to postacquisition liabilities.
In this case, Alpha agreed that it was aware of the liabilities at the time of acquisition. In addition, the company expressly assumed the liabilities. Alpha argued that it could have avoided the liabilities because bankruptcy law would have permitted the sale of assets without the assumption of the liabilities. However, the IRS noted that Alpha agreed to assume the liabilities in exchange for the assets in an arm’s-length transaction. In that transaction, Alpha chose the liabilities it wished to assume in light of the value of the assets it was acquiring. Once the transaction was completed, Alpha could no longer avoid the liabilities.
Accordingly, the IRS concluded that the assumed liabilities are subject to capitalization. The fact that the liabilities were assumed in connection with the acquisition of assets in a transaction described in Section 363 and Section 365 of the Bankruptcy Code does not, in and of itself, preclude capitalization.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 See CCA 201036009, May 25, 2010.
2 See David R. Webb Co., Inc. v. Commissioner, 708 F.2d 1254 (7th Cir. 1983).
3 See Illinois Tool Works v. Commissioner, 355 F.3d 997 (7th Cir. 2004).