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Archive for August 29th, 2012

Expanding on our post from earlier today, assume that as part of an M&A transaction, a buyer agrees to pay $10,000,000 to an investment banker upon the successful closing of the deal.This type of lump-sum fee paid upon consummation is quite common, and is typically referred to as a “success-based fee.”

Prior to 2011, the regulations at Treas. Reg. §1.263(a)-5 provided the general rule that a success-based fee facilitated a transaction, and thus was generally nondeductible. A taxpayer was permitted, however, to rebut this presumption by maintaining sufficient documentation to establish that portions of the fee were 1. not inherently facilitative to the transaction, and 2. incurred prior to the “bright-line test date,” in which case they would be currently deductible.

Anyone that has ever completed a transaction cost study knows that this was an onerous requirement, forcing the taxpayer (and the tax advisor) to sort through what could be several years worth of documents to prove that a portion of the success-based fee was being paid for services that met both tests required for current deduction.   

In Revenue Procedure 2011-29, the IRS greatly liberalized the treatment of success-based fees by providing a safe harbor, whereby a taxpayer could treat 70% of a success based fee as an amount that did not facilitate the transaction and deduct it currently while only being forced to capitalize the remaining 30%. Using the number above, $7,000,000 of the success-based fee would be deducted, and $3,000,000 capitalized.

But what if prior to paying the success-based fee, the taxpayer is required to make non-refundable milestone payments to the investment banker?  What if instead of paying the $10,000,000 only upon the closing of the deal, the taxpayer was required to fork over a $1,000,000 payment upon the signing of the LOI and an additional $1,000,000 upon shareholder approval of the transaction, with the payments being credited to the $10,000,000 due upon completion of the deal? Would those $2,000,000 in payments qualify for the safe harbor 70/30 election?

According to an IRS Ruling issued last week, the answer is no. In CCA 201234027, the IRS concluded that because the milestone payments were not refundable, they were not “success-based fees.” Seems logical to me. And because they were not “success-based fees,” they were not eligible for the RP 2011-29 safe harbor. As a result, in order to deduct any of the $2,000,000 in payments, the taxpayer was required to establish, based on all the facts and circumstances, that the investment banker’s activities were 1. not inherently facilitative and 2. incurred before the bright-line test date.

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When finalized in 2003, the Section 263(a) regulations governing the treatment of transaction costs changed the way we treat expenses incurred by both an acquiring and target company pursuant to an acquisition. Under these regulations — specifically, Treas. Reg. §1.263(a)-2T(c)(3) — the general rule is that no deduction is allowed for an amount paid to acquire or create an intangible, which under Treas. Reg. §1.263(a)-4(c)(1)(i), includes an ownership interest in a corporation or other entity.

Stated in a more simple manner, if you own a business that is either acquiring another business or being acquired, any expenses incurred by the business as part of investigating, pursuing or closing the transaction are generally not deductible.[i]

The regulations provide an exception to this general rule, however. If certain transaction costs are incurred prior to a “bright-line test date,” provided those costs are not “inherently facilitative” to the transaction[ii], the business can deduct the costs currently.

The key, then, is what constitutes the “bright-line test date.”  The regulations at Treas. Reg. §1.263(a)-5 define this date as the earlier of:

1. the date on which a letter of intent, exclusivity agreement, or similar written communication is executed by representatives of the acquirer and target, or

2. the date on which the material terms of the transaction are authorized by the taxpayer’s board of directors.

So, in summary, all costs before the earlier of those two dates may be deducted, provided they are not inherently facilitative. Once you hit that point of no return, however, all costs incurred in pursuit of the transaction must be capitalized.

Last Friday, in CCA 201234026 the IRS addressed the impact a “go shop” provision has on this bright-line test date. In the Ruling, an acquirer and target had set the terms of an agreement in a merger agreement that was executed by representatives of both corporations and approved by both corporations boards. In other words, the bright-line test date had been reached.

The agreement, however, also contained a “go shop” provision that provided that after the date of the merger agreement, Target was permitted to seek better offers from potential acquirers. If Target found a better deal, Target could cancel the merger agreement and choose the better option, or the acquirer could match the terms of the better deal.

The taxpayers argued that the “go shop” provision extended the bright-line test date until the time that the provision expired and the deal was consummated. The IRS disagreed.

The “go shop” provision is only one of the terms of the merger agreement and does not serve to negate the document’s execution, nor does it trump the approval of those terms by the corporations’ boards of directors. Therefore, the bright-line date is the date of the merger agreement’s execution and its approval by the corporations’ board of directors.  


[i] See also Treas. Reg. §1.263(a)-5(a).

[ii] Amounts are inherently facilitative if they are paid to: (1) secure an appraisal, formal written evaluation, or fairness opinion; (2) structure the transaction (including the negotiation of the structure and the obtaining of tax advice on the structure); (3) prepare and review the documents that effectuate the transaction; (4) obtain regulatory approval for the transaction; (5) obtain shareholder approval for the transaction; or (6) convey property between the parties. General due diligence costs are not considered inherently facilitative but, rather, are to be analyzed under the bright-line date rule.

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