In the typical corporate or private equity transaction, both the buyer and seller incur significant service provider costs, often in the millions or tens of millions of dollars, in connection with the closing of a transaction. In most cases, a substantial portion of these costs are success-based fees contingent upon closing. The treatment of success-based fees is a factually intense issue that has been full of uncertainties, especially with respect to the appropriate documentation. Recently issued administrative guidance has cleared up some of the uncertainties, but also has added a few new ones to the mix for the buyer.
Background: Tax Treatment of Buyer Transaction Costs
Without any analysis, the general presumption is that all transaction costs are facilitative of the transaction and, depending upon the type of transaction, must be capitalized into the value of the stock or assets. However, for certain acquisitive “covered transactions” (defined in Treasury Regulation Section 1.263(a)-5(f)), a portion of the costs may be treated as non-facilitative of the transaction and, depending on the facts, such costs would be currently deductible or amortizable. Furthermore, the regulations contain other simplifying conventions and special rules that apply to debt financing costs and compensation and benefits costs. Below are the general categories for the treatment of transaction costs:
Debt financing costs: Costs incurred in connection with obtaining debt financing, including reviewing and negotiating the terms of the financing, are amortized over the life of the debt.
Compensation and benefits costs: Costs incurred in connection with employee compensation, including drafting and negotiating the employment and option agreements, are currently deductible.
Pre-bright line date costs: Costs incurred prior to the bright line date (BLD), generally referred to as the date on which the taxpayer and target decide to move forward with the transaction, are not treated as facilitative. The BLD usually coincides with the date the buyer enters into a letter of intent. Such costs may be treated as deductible business expansion costs if the acquirer is a pre-existing entity, or as start-up costs amortizable over 15 years if the entity is newly formed.
Post-bright line date and inherently facilitative costs: Costs incurred post-BLD and certain inherently facilitative costs (e.g., securing an appraisal, structuring the transaction, obtaining shareholder approval, and preparing and reviewing documentation to effectuate the transaction) are treated as capital.
The following are typical transaction costs incurred by a buyer:
Legal (diligence, purchase agreement, financing, employment and benefits) fees
Accounting (financial and tax diligence) fees
Operational diligence or industry analysis fees
Environmental diligence fees
Insurance and benefits
Investment banking and finder fees
Private equity sponsor fees
By performing a transaction cost analysis, all of the transaction costs can be reviewed and analyzed to ensure that the taxpayer receives the benefits to which it is entitled. For instance, often in the case of a financial buyer, there is no existing business and the acquisition costs allocated to the pre-BLD are treated as amortizable over 15 years. To the extent that such costs can be allocated to debt financing, the costs will be amortized over a shorter period, with the balance written off upon repayment, which can often provide enhanced value for a financial buyer upon exiting an investment.
Success-Based Buyer Fees
Typically, the largest fees associated with a transaction are the success-based investment banking fees, finder’s fees and private equity sponsor fees. In a covered transaction, success-based fees are presumed to be facilitative except to the extent that the taxpayer maintains “sufficient documentation” establishing that a portion of the fee is allocable to non-facilitative activities. The documentation required under the applicable regulations must consist of time records, itemized invoices or “other records” that identify:
(i) Activities performed;
(ii) Amount of the fee (or percentage of time) allocable to each activity;
(iii) Date the activity was performed if relevant for purposes of determining whether the activity is facilitative; and
(iv) Name, business address and phone number of the service provider.
The type and extent of documentation required to establish that a portion of the success-based fee is allocable to non-facilitative activities has been an area of controversy between taxpayers and the IRS because investment bankers and private equity firms do not maintain detailed time records. While some guidance has been provided in private letter rulings about what constitutes sufficient documentation, there is still a great deal of uncertainty. In an attempt to reduce such controversies and provide taxpayers relief from disagreements with the IRS about the proper documentation for deductible non-facilitative costs, the IRS issued Revenue Procedure 2011-29, which provides a safe harbor election for allocating success-based fees between activities that are facilitative and non-facilitative of a covered transaction.
Safe Harbor Election
Pursuant to Rev. Proc. 2011-29, if a taxpayer pays or incurs a success-based fee in connection with a covered transaction and makes an election, the IRS will not challenge the taxpayer’s allocation of a success-based fee between facilitative and non-facilitative activities if the taxpayer treats 70 percent of the success-based fee as non-facilitative and capitalizes the remaining 30 percent as facilitative. The revenue procedure is irrevocable once made and applies to all success-based fees incurred in connection with the transaction. Furthermore, it is effective for success-based fees paid or incurred in taxable years ending on or after April 8, 2011. (It should be noted that the Treasury did not foreclose the possibility of IRS exam and appeals to defer to a 70 percent allocation as a means of resolving pending transaction cost controversies.)
While this administrative guidance should reduce controversy about the documentation of non-facilitative success-based fees, there are still unanswered questions. For instance, the revenue procedure does not address the proper allocation of costs once the taxpayer has made the 70/30 split. The IRS has stated that, in this case, the taxpayer has the opportunity to make a reasonable bifurcation of the costs. Presumably, the non-facilitative portion (70 percent) could be bifurcated between pre-BLD activities (deductible or amortizable over 15 years), financing activities (amortizable over the life of the debt) and compensation and benefits activities (currently deductible). If the taxpayer were able to allocate among these categories, it would be prudent to conclude that normal documentation to support its positions would still be required. However, the level of documentation that required was not addressed in the revenue procedure.
Should the Buyer Make the Safe Harbor Election?
As previously mentioned, the election is irrevocable, so it is crucial to give careful consideration prior to making the election. Consistent with the evaluation of transaction costs, this depends on the specific facts in each transaction and, as such, the costs must be evaluated on a case-by-case basis.
For instance, the election would be beneficial in situations where the BLD was triggered early on in the acquisition process, as the 70 percent allocation could very well be more beneficial. However, there are other scenarios where the taxpayer may receive a better answer by performing an analysis of the costs. For example, in an auction process, the acquirer of a company will perform a substantial amount of work prior to the BLD on non-inherently facilitative activities, such as researching the business and marketplace, financial diligence, legal diligence, and tax diligence. In this situation, the actual amount of time spent on non-facilitative activities is likely to be greater than the 70 percent provided in the safe harbor.
Alvarez & Marsal Taxand Says:
Rev. Proc. 2011-29 clearly gives buyers some clarity on the level of the success-based fees that are deductible as non-facilitative (70 percent) where historically it has been difficult to produce the needed documentation. It also seems to be an indication of how the IRS may settle the treatment of success-based fees for pre-effective date transactions under audit. However, it also raises some questions as to how to treat the non-facilitative portion of the success-based fees that will be deductible. It seems reasonable for a buyer to allocate the success-based fees to the different categories of transaction costs as opposed to assuming the entire non-facilitative portion is amortizable over 15 years. Such an allocation of costs will likely allow for a recovery over a shorter life, but will require the necessary documentation to support the allocation. Furthermore, before deciding to make the safe harbor election, buyers should consider their particular facts and circumstances in order to determine whether the election will actually be beneficial.
The initial reaction to the revenue procedure among practitioners was that buyers would no longer need to perform a transaction cost analysis in light of the fact that the success-based fees are normally a material portion of the overall transaction costs. However, although the election does provide a level of certainty, it is still beneficial for a buyer to undertake the necessary analysis and documentation to obtain the optimal benefit of the deductible portion of the success-based transaction costs.
Managing Director, Chicago
Krista Servidio, Director, and Kinga Staromiejska, Senior Associate, contributed to this article.
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