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.