Update on Transaction Costs - 'Origin of the Claim' Analysis Will Decide Tax Allocations - Tax Update Volume 2017, Issue 3

As is illustrated by the recent guidance from the IRS with respect to transaction costs, documentation is key.

While the Internal Revenue Service (IRS) has continued to issue guidance addressing the ability to deduct transaction costs, the doctrine of "Origin of the Claim" (OOC) developed over 50-plus years of case law is still the gold standard for performing an allocation of costs as deductible, capitalized, or capitalized and amortizable.1 The courts and the IRS have further refined the OOC doctrine with respect to the proper tax treatment of transaction costs by addressing the nuanced concept of whether a particular cost is related to investigating, pursuing or facilitating a transaction, or is a type of cost that would ordinarily be paid by the taxpayer as part of its ongoing business activities.2 This article reviews recent IRS guidance confirming this methodology of transaction cost allocation, and addresses the continued importance of documenting the facts surrounding a transaction and each of the service provider’s roles in performing activities related to the business of the taxpayer, and/or with respect to a particular transaction that the taxpayer is undergoing.

General Rules of Deduction vs. Capitalization of Transaction Costs

In general, Treas. Reg. Section 1.263(a)-5, et seq., was adopted to provide a regulatory regime for the treatment of transaction costs incurred to facilitate an acquisition of a trade or business. The Internal Revenue Code, Treasury Regulations, IRS rulings and case law have historically found that taxpayers may divide transaction costs into three categories: (i) deductible under Sections 162 and 165, (ii) capitalizable and amortizable under Sections 163, 167, 168, 195, 197 and 248, and (iii) capitalizable costs subject to Section 263.

Section 162(a) generally allows a current deduction for those ordinary and necessary business expenses incurred in a taxpayer’s trade or business. A cost that is otherwise deductible may not be immediately deducted if it is a capital expenditure, which is a cost that yields future benefits to the taxpayer’s business. Treas. Reg. Section 1.263(a)-5(a), requires a taxpayer to capitalize an amount paid to facilitate any one of 10 specified transactions. A facilitative cost includes a cost incurred to pursue or investigate a transaction. A transaction cost is generally required to be capitalized if no allocation and no documentation is assembled with respect to that allocation. In particular, for success-based fees incurred in a transaction, specific contemporaneous documentation must support an allocation of such costs, unless the taxpayer is eligible for, and makes a safe harbor election for such costs pursuant to Rev. Proc. 2011-29, and files the election statement with the tax return in which such costs are taken into account.3

CCA 2017130104

Treas. Reg. Section 1.263(a)-5(e)(2)(iv) provides that an amount is "inherently facilitative" of the transaction regardless of when it was incurred if the fees were for "[o]btaining regulatory approval of the transaction, including preparing and reviewing regulatory filings." In Chief Counsel Advice 201713010, the IRS examining agent took the position that several specific costs that were paid by the taxpayer as a condition to receiving the required approval for the transaction from a regulatory board that, under relevant law, governed companies in the taxpayer’s business, were required to be capitalized. The IRS agent was making the case that because the four specific types of costs (funding of a capital rate, contribution to a customer investment fund, payments to a state for certain development activities, and amounts contributed to charitable organizations in the local community), were all "required" by the regulatory board to obtain its approval for the transaction, they were inherently facilitative under Treas. Reg. Section 1.263(a)-5(e)(2)(iv). The IRS agent was seeking a finding from the IRS National Office that such costs were incurred to comply with a regulatory board’s approval, and were per se required to be capitalized under the Section 263 regulations.

The National Office of the IRS disagreed, and pointed to the preamble to the proposed version of the Section 263 transaction cost regulations in distinguishing between the concept of "facilitate" and "but-for." The National Office pointed out that the "but-for" test, i.e., but for the transaction the costs would not have been incurred, was specifically discarded as the appropriate standard. Instead, the regulations focus on costs that are paid to service providers to investigate or pursue a transaction. In making this distinction, the National Office pointed to several costs that may not have been paid "but for" the transaction, including workforce reduction, integration costs, costs to acquire tangible property, general operating costs, etc., and pointed out that none of these costs would be treated as facilitative, even though the obligation to pay them arose because of the transaction.

Arguably, the National Office narrowed the scope of the fees that required capitalization to those that were paid to the lawyers and others who might have drafted requests to the regulatory board, but not to amounts that regulatory board required the taxpayer to pay to obtain such board’s approval. The IRS looked to the origin of the services provided to incur the payments at issue, and asked whether each particular payment was for a service that assisted the taxpayer with preparing or reviewing regulatory filings. In the CCA, none of the payments listed were paid to service providers that were "preparing and reviewing" regulatory filings.

PLR 2017110035

Since the issuance of Rev. Proc. 2011-29, taxpayers have been seeking 9100 relief for situations in which an election to apply the safe harbor allocation of 70 percent non-capitalizable, and 30 percent capitalizable to their success-based fees was missed, and inadvertently left off of their tax return for the year in which the success-based fees were paid. Without being able to file the safe harbor, the taxpayer would default into the general treatment for all transaction costs, which is capitalization. Permission to file a late safe harbor election can allow the taxpayer to access millions of dollars in deductions they would not otherwise be able to support.

In Private Letter Ruling 201711003, the taxpayer hired an accounting firm to prepare its short period tax return that would take into account the transaction costs paid by the taxpayer in the transaction in which the taxpayer was acquired. The accounting firm prepared the taxpayer’s short-period return and caused the taxpayer to deduct all of the transaction costs incurred in the transaction that were expensed for financial reporting purposes. Taxpayer did not have any in-house tax personnel, and was relying on the accounting firm to advise it of the proper tax treatment of these transaction costs, as well as other items on the tax return. The taxpayer stated that neither it, nor the accounting firm, prepared documentation supporting the deduction of the transaction costs paid by the taxpayer. In addition, the accounting firm did not inform the taxpayer of the need to provide documentation or to make any elections with respect to its deduction of transaction costs. Because no documentation was assembled before the deduction being taken on the tax return, there would be no basis for the taxpayer to demonstrate to the IRS that under an OOC analysis, the costs that were deducted were not facilitative of the transaction. The ability to provide documentation, contemporaneous with the tax positions taken on a return, is crucial to supporting any type of deduction for transaction costs.

The acquiring company learned of this error after it acquired the taxpayer, and initiated discussions with a tax advisor to see if this mistake could be corrected through obtaining 9100 relief in order to make the safe harbor election under Section 2011-29. The IRS granted the taxpayer’s request to file the safe harbor election of 2011-29 with respect to its success-based fees, but was silent on whether the taxpayer would be able to assemble the required documentation and adjust the allocations of the remaining fees (non-success-based fees) in order to support the deductions taken on the short period tax return.6

Pepper Perspective

As is illustrated by the recent guidance from the IRS with respect to transaction costs, documentation is key. The OOC doctrine still applies in any attempt by a taxpayer to take a deduction for the costs incurred and paid with respect to a transaction. Importantly, the IRS will hold itself to the OOC as well. This is demonstrated by its analysis in CCA 201713010, where it confirms that a "but-for" analysis does not apply in the allocation of transaction costs, and that each cost at issue must be evaluated to determine the origin of such cost and whether it is a cost paid to a service provider that is providing services related to investigating or pursuing the transaction. Because of the confirmation that is suggested in the CCA, that the term "costs that facilitate the transaction" is intended to apply to a narrow group of costs related to very specific activities, taxpayers who carefully document all the fees and expenses incurred in the pendency of a transaction may be able to maximize their deductions.

The importance of assembling that documentation before filing the return is implied by the narrow ruling in PLR 201711003, that allows the taxpayer to file the safe harbor election under Rev. Proc. 2011-29, but is silent on the risks associated with the lack of documentation on the other non-success based fees that were deducted by the taxpayer. There is no substitute for assembling contemporaneous documentation and applying a detailed OOC analysis to the amounts paid in a transaction to support any deductibility positions taken on a tax return for the year the transaction costs are paid.

Endnotes

1United States v. Gilmore, 372 U.S. 39 (1963), cited by the IRS in FAA 20141001F (January 29, 2014) in determining whether certain underwriting costs were incurred to extinguish an existing debt or to enter into a new debt facility.

2 See, INDOPCO, Inc. v. Commissioner, 50 U.S. 79 (1992), and the preamble to the proposed version of Treas. Reg. 1.263(a)-5 (67 F.R. 77701-01, 2003-1 C.B. 373), in which the IRS clarifies that the standard of capitalizing a cost that facilitates a transaction is narrower than a "but-for" standard.

3 The Rev. Proc. 2011-29, 2011-1 C.B. 746, election is available only for certain success paid fees paid in connection with a "covered transaction" which includes, (i) "[a] taxable acquisition by a taxpayer of assets that constitute a trade or business", (ii) a taxable acquisition of the ownership interests in a business entity (whether the taxpayer is the acquirer in the transaction or the target in the transaction) where the acquirer and the target a related within the meaning of Section 267(b)or Section 707(b) immediately after the transaction, and (iii) a reorganization generally described in Section 368(a)(1)(A), (B), or (C), and in certain instances, Section 368(a)(1)(D).

4 (December 20, 2016).

5 (December 23, 2016).

6 In general, the IRS view has been fairly consistent that once a position is taken on a return with respect to a transaction cost, that position becomes a method of accounting for federal income tax purposes with respect to those costs and cannot be amended without requesting a method change, either through any available automatic method change procedures or through filing a Form 3115 request.