Number 248 January 15, 2003 Client Alert Latham & Watkins Tax Department Treasury Proposes New Regulations for Capitalization of M&A Costs The proposed regulations are very comprehensive and implement a number of important and beneficial changes... On December 18, the Treasury Department issued proposed regulations addressing the treatment of costs incurred in connection with intangible assets and with certain corporate transactions. The proposed regulations are very comprehensive and implement a number of important and beneficial changes including: modifying the effect of the Supreme Court s capitalization rule in INDOPCO 1 by establishing a presumption if a deduction of the item is not described as a capital expenditure, and dramatically limiting the role of the significant future benefit standard; establishing new standards regarding the treatment of costs that are routinely incurred in corporate mergers, acquisitions and spin-offs, such as employee compensation and overhead; enacting a 15-year safe harbor amortization period for costs incurred to create certain intangible assets; 2 and establishing a 12-month rule that permits deduction of intangible asset costs where the assets have a relatively short duration. The proposed regulations address several areas of particular significance in the area of corporate mergers and acquisitions including the treatment of routine facilitative expenses, the treatment of investigatory expenses and the treatment of divisive reorganization expenses. The new standards for the treatment of these expenses raise a number of issues which are discussed below. Treatment of Corporate Acquisition Costs The proposed regulations attempt to provide simplified, bright-line rules for the capitalization of transaction costs in corporate mergers and acquisitions. In general, amounts paid to facilitate a restructuring, reorganization or transaction involving the acquisition of capital are subject to capitalization. Prop. Reg. 1.263-4(b)(1)(iii). 3 An amount facilitates a transaction if it is incurred in the process of pursuing the transaction, as determined by a facts and circumstances test. Prop. Reg. 1.263-4(e)(1)(i). The facilitate standard is intended to be narrower in scope than a but for standard. The fact that an amount would or would not have been paid but for the transaction is not relevant in determining whether the amount is paid to facilitate the transaction. See id. For example, this would allow the deduction of plant closing costs. Most expenditures will be determined to be facilitative through the application of the facts and circumstances test noted above. The proposed regulations do however establish specific categories of facilitative and non-facilitative expenses. The following expenditures do not facilitate a capital transaction and are therefore not required to be capitalized under the proposed regulations: Latham & Watkins operates as a limited liability partnership worldwide with affiliates in the State of Illinois, where the practice is conducted through an affiliated limited liability company, and in the United Kingdom and Italy, where the practice is conducted through an affiliated multinational partnership. Copyright 2003 Latham & Watkins. All Rights Reserved.
Overhead and compensation to employees (whether paid in the form of salary, bonus or commission). Prop. Reg. 1.263-4(e)(3)(i); Preamble to Proposed Regulations V(D)(1). However, the Treasury has indicated that taxpayers who deduct overhead and compensation costs will likely be subject to a book-tax conformity requirement. Integration costs. Amounts paid to integrate the business operations of the acquiror and the target, regardless of when the integration activities occur. Prop. Reg. 1.263-4(e)(4)(i)(D). Hostile takeover defense costs. Transaction costs incurred by a taxpayer to defend against a hostile takeover of the taxpayer. Prop. Reg. 1.263-4(e)(4)(iii). However, once an acquisition ceases to be hostile, costs incurred thereafter are considered facilitative. De minimis transaction costs. The proposed regulations define de minimis costs as costs that do not exceed $5,000, determined on a transaction-bytransaction basis. The proposed regulations permit taxpayers to determine the applicability of the de minimis rules by computing the average transaction cost for a pool of similar transactions. Prop. Reg. 1.263-4(e)(3)(ii). The following expenditures do facilitate a capital transaction and may be required to be capitalized under the proposed regulations: Termination payments. Amounts paid to terminate an existing agreement if the transaction is expressly conditioned on the termination of such agreement. Prop. Reg. 1.263-4(e)(1)(ii). 4 Success-based fees. Amounts paid that are contingent on the successful closing of an acquisition except to the extent that some portion of the amount is allocable to activities that do not facilitate the acquisition. Prop. Reg. 1.263-4(e)(4)(i)(C). Assuming a cost is considered facilitative, whether it must be capitalized or can be amortized under section 195 depends in part on certain criteria set forth in the proposed regulations with respect to investigatory costs. Treatment of Investigatory and Non-Investigatory Costs The proposed regulations provide a bright-line rule for determining at what point the costs of acquiring a trade or business cease to be investigatory and must be capitalized. This rule signals a rejection of the whether and which test previously articulated by the IRS in Revenue Ruling 99-23, which required taxpayers to engage in a difficult facts and circumstances analysis to distinguish the costs of investigating an acquisition (which generally are amortizable) from the costs of facilitating the acquisition (which must be capitalized). See Preamble to Proposed Regulations V (B). Under the bright-line rule in the proposed regulations, capitalization of facilitative costs is required only if: The amount is inherently facilitative ; or The amount relates to activities performed after the earlier of the date a letter of intent or similar written communication is submitted to the target or the date the taxpayer s Board of Directors approves the acquisition proposal. Prop. Reg. 1.263-4(e)(4)(i) (A), (B). The proposed regulations provide an exclusive list of nine activities that are inherently facilitative : determining the value of the target negotiating or structuring the transaction drafting transactional documents preparing and reviewing regulatory filings required by the transaction obtaining regulatory approval of the transaction 2 Number 248 January 15, 2003
securing advice on the tax consequences of the transaction securing an opinion as to the fairness of the transaction obtaining shareholder approval of the transaction conveying property between the parties to the transaction. Prop. Reg. 1.263-4(e)(4)(i)(B). Thus, an amount paid for an activity that is facilitative but does not appear on the above list is not required to be capitalized unless it is performed after the earlier of the date a letter of intent is executed or the date the taxpayer s Board of Directors approves the acquisition proposal. Prop. Reg. 1.263-4(e)(4)(i)(A). The IRS and Treasury Department have requested comments on whether the bright-line standard for inherently facilitative costs is administrable and whether there are other bright-line standards that can be applied in this area. Comments have also been requested on the types of records that are available in the context of an acquisition of a trade or business and how these records might be utilized to administer the bright-line rule for the timing of facilitative activities. The scope of certain of the inherently facilitative categories is not entirely clear. Example 9, Prop. Reg. 1.263(a)-4(e)(7), raises an interpretative issue regarding what is considered due diligence as opposed to determination of the target value. In this example, a corporation investigates the acquisition of three potential target corporations and conducts due diligence on all three potential targets. Since due diligence is not one of the nine inherently facilitative activities, the amounts paid to an investment banker and to outside counsel to conduct due diligence on the targets prior to the issuance of any letter of intent are not required to be capitalized. However, once the acquiring corporation issues a letter of intent to one target and stops pursuing the others, the amounts paid to conduct due diligence on the chosen target on or after the date of the letter of intent must be capitalized. In addition, the amounts paid to determine the target s value, negotiate and structure the transaction, draft the merger agreement, secure shareholder approval, prepare SEC filings and obtain necessary regulatory approvals are inherently facilitative and must be capitalized, regardless of whether those activities occurred prior to the issuance of the letter of intent. The amounts paid to determine the value of the corporations that were not acquired must also be capitalized because they are inherently facilitative. The above example is confusing because it implies that due diligence and value determination are entirely separate activities, with capitalization being required for value determination but not for due diligence. Since due diligence often, in fact, encompasses value determination, it is unclear how to distinguish between the two for capitalization purposes. This issue may be resolved before the proposed regulations are finalized. Divisive Transactions The proposed regulations identify one important subset of corporate transaction costs that must generally be capitalized, namely, those costs that facilitate a divisive transaction such as a spin-off or taxable asset sale. Prop. Reg. 1.263-4(e)(4)(ii). As precedent for the requirement of capitalization in these instances, the preamble to the proposed regulations cites Bilar Tool & Dye Corp. v. Commissioner, 530 F.2d 708 (6th Cir. 1976), in which the court held that costs incurred in a divisive transaction must be capitalized because the transaction adds value to the capital structure of the corporations involved. Under the proposed regulations, costs to facilitate a distribution of stock to shareholders are not capitalized if the divestiture is required by law and does not itself facilitate a separate restructuring or reorganization transaction. See Prop. Reg. 3 Number 248 January 15, 2003
1.263-4(e)(4)(ii)(A). This standard is not entirely consistent with the case law. The exception identified by the Treasury is based on the facts of certain cases. See, e.g., General Bancshares, 388 F.2d 184 (8th Cir. 1968); United States v. Transamerica Corp., 392 F.2d 522 (9th Cir. 1968). In these cases, the taxpayer underwent a divisive reorganization because of newly enacted legislation. However, the fact that the reorganization was involuntary does not appear to be material to the rationale articulated in these cases for allowing the deduction of the reorganization costs. The reasoning supporting deductibility in these cases is that no new asset, right or capital is acquired by the contracting business, so there is no asset/benefit with respect to which the costs should be capitalized. Thus, even if a spin-off or a reorganization occurs without a forced divestiture, if the purpose and effect is a liquidation or contraction of business, related expenses should be able to be deducted. See Gravois Planing Mill Co. v. Commissioner, 299 F.2d 199 (8th Cir. 1962) (holding that legal fees and expenses incurred to effect a plan of liquidation were deductible where dominant purpose of plan was the contraction of the business). Indeed, the proposed treatment of divisive reorganization costs seems out-of-step with the Treasury s rejection of INDOPCO s significant future benefit standard as the appropriate measure of capitalization. Since a liquidation or contraction does not ordinarily result in the acquisition of any new assets, the only grounds for capitalization in these circumstances would appear to be whatever future benefits flow from the contracted corporate operations. Moreover, the proposed regulations set up a disparity of treatment between divisions effected by a stock distribution and those effected through taxable asset sales. Unlike the treatment of stock distributions, the proposed regulations treatment of taxable asset sales is facially inconsistent with the preamble s general rule of capitalization for the costs of divisive transactions. According to the proposed regulations, an amount paid to facilitate the taxable sale of assets is not required to be capitalized unless the sale is required by law, regulatory mandate or court order and the sale itself facilitates another transaction. See Prop. Reg. 1.263-4(e)(4)(ii)(B). Thus, capitalization in the context of taxable asset sales appears to be the exception, not the rule. The proposed regulations underscore this point by offering the following example: if a target corporation, in preparation for a merger with an acquiror, sells assets that are not desired by the acquiror, amounts paid to facilitate the sale are not required to be capitalized as amounts paid to facilitate the merger. See id. It is difficult to reconcile this example with the rationale of capitalizing those costs that add value to the capital structure of a corporation, since the sale of assets not desired by an acquiror arguably makes the corporation more attractive to the acquiror. Approaching Acquisition Costs Pending Finalization Pending finalization of the proposed regulations, we recommend that clients carefully collect information supporting the treatment of acquisition costs as either capital or non-capital (i.e. amortizable under section 195 or deductible). Critical to this preparation is an understanding of the timeline of events including the preacquisition activities of both the acquiror and the target and the events surrounding the offer and acceptance of acquisition terms. With respect to the latter, the submission of a letter of intent and Board approval are the most significant and should be delayed as long as possible. We also recommend that, even prior to closing, clients make inquiries with their professional service providers, such as investment bankers, accountants and lawyers, regarding the nature of the services they are providing with respect to the acquisition and the fees allocable to those services. 4 Number 248 January 15, 2003
Comment Period and Proposed Effective Date The IRS has requested comments on numerous aspects of the proposed regulations, which are due by March 19, 2003 and has scheduled a public hearing for April 22, 2003. The proposed effective date is the date of publication of the final regulations in the Federal Register. Endnotes 1 In INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992), the Supreme Court held that expenditures related to the production of income must be capitalized if they produce a significant future benefit. The significant future benefit standard has been universally criticized by tax practitioners as an unworkable standard. Treasury essentially agreed with this criticism. 2 3 4 The safe harbor is inapplicable for capitalized transaction costs that facilitate a restructuring or reorganization of a business entity. Among the types of transactions for which capitalization is required are tax-free reorganizations, stock issuances (except for the stock issuance costs for certain investment companies), borrowing and recapitalizations. Prop. Reg. 1.263-4(b)(1)(iii); 1.263-4(e)(6). Under the new proposed regulations, costs incidental to the pursuit of a transaction should not be treated as facilitative. For example, a company s payments to bondholders to secure consent to modify an existing indenture agreement in order to obtain new financing should not be considered facilitative even if incurred in the context of a merger transaction so long as the transaction is not conditioned on securing those consents. 5 Number 248 January 15, 2003
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