United States: New Directive Correctly Resolves Use Of Transaction Cost Safe Harbor For Milestone Payments – Questions Nonetheless Linger

A new directive specifies that Large Business & International (LB&I) examiners should not challenge a taxpayer's treatment of eligible milestone payments when success-based fees¹ are incurred, provided a safe harbor election pursuant to Rev. Proc. 2011-29² has been made.³ This directive provides welcome relief and suggests a reversal of the Internal Revenue Service's previous position regarding milestone payments.

Under the Rev. Proc. 2011-29, a taxpayer may elect to treat 70 percent of all success-based fees as nonfacilitative, and treat the remaining 30 percent of the success-based fee as capitalizable. With the election, taxpayers may forgo the challenging task of maintaining the documentation required in Treas. Reg. 1.263(a)-5(f) to support the allocation of these transaction costs. Although the revenue procedure makes clear the treatment of success-based fees, the Service restricted its application in a subsequent technical memo. In CCA 201234027,⁴ the IRS National Office addressed the treatment of milestone payments and found that such payments did not qualify for the safe harbor. Thus, even though the safe harbor offered simplification, that simplicity was restricted by the Service interpretation.

The new directive provides relief to corporate taxpayers because LB&I examiners are instructed not to challenge the treatment of milestone payments paid to investment bankers in connection with a covered transaction when a safe harbor election is made. The directive is applicable to investment banking fees incurred by either an acquiring corporation or a target corporation. It does not apply to other success-based fees, (e.g., legal, consulting, or accounting fees.)

Because the safe harbor, once elected, must be applied to all success fees, it may be inferred that all other success fees will continue to be scrutinized at examination. Moreover, the directive is limited to amounts deducted on original timely filed returns and does not apply to claims or amended returns. Although this directive is appreciated, it falls short of the relief required by companies undergoing corporate transactions. Further, the directive serves as a reminder that a number of technical questions regarding the treatment of transaction costs remain unanswered.

Background - Treatment of Transaction Costs

Proper cost allocations are grounded in the "origin of the claim" doctrine, under which "the origin and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling basic test of whether the expense is deductible or not."⁵ In Woodward v. Commissioner,⁶ the Supreme Court applied the origin of the claim doctrine to corporate transaction costs, finding that the nature of the transaction governs whether an item is a deductible expense or a capital expenditure. Following the Court's rationale in Woodward, the Seventh Circuit in A.E. Staley Manufacturing Co. v. Commissioner⁷ applied an origin of the claim approach and permitted the taxpayer to allocate a lump-sum investment-banking fee between deductible and capital categories. In Wells Fargo & Co. v. Commissioner,⁸ the Eighth Circuit similarly followed the Supreme Court's precedent and allowed a taxpayer to deduct salaries and other indirect merger expenses. In addition, the Eighth Circuit held that the legal expenses incurred before the final merger decision date were deductible, and the remaining portion of the legal expenses after the decision date were required to be capitalized.

In Wells Fargo, thecourt relied on Rev. Rul. 99-23⁹ to analyze the taxpayer's costs. Although technically limited to Section 195 and start-up expenditures, Rev. Rul. 99-23's conclusions that investigatory costs are amortizable as start-up expenditures is premised on the deductibility of such costs in the context of the operation of an existing business. The ruling finds that preliminary and investigatory costs are deductible while costs attributable to completing the transaction are not.

Against this background, the Section 263(a) Regulations incorporated the concepts developed in Wells Fargo and its predecessor cases. These Regulations provide that costs incurred while investigating one of ten specified transactions are facilitative€"and thus capitalized and not deducted. With respect to certain transactions, "covered transactions," (e.g., stock acquisitions, business asset acquisitions, or acquisitive tax-fee reorganizations), investigatory costs may be deducted if the amount relates to activities performed on or after the decision to acquire.¹⁰ The Regulations list a number of inherently facilitative services that must be capitalized regardless of when they are performed, but for investigatory and other non-inherently facilitative costs incurred to pursue a covered transaction, the costs incurred prior to the decision to acquire are not facilitative and may be deducted.¹¹

For success-based fees in particular, Treas. Reg. § 1.263(a)-5(f) presumes that payments contingent upon a successful closing facilitate the transaction, and these fees generally are capitalized. Success-based fees are defined broadly in Treas. Reg. § 1.263(a)-5(f) as amounts contingent on the successful closing of a transaction. The taxpayer may rebut the presumption of non-deductibility by maintaining sufficient documentation establishing an allocation to non-facilitative activities. Under these Regulations, the documentation must be completed on or before the due date of the taxpayer's timely filed, original federal income tax return (including extensions) for the taxable year during which the transaction costs were paid.¹²

The Regulations provide that supporting records to establish sufficient documentation include: time records, itemized invoices, or other records that identify the activities performed by the service provider; the amount of the fee allocable to each of the various activities; the date of services (when relevant); and the name, business address, and telephone number of the service provider.¹³ Other guidance in a private letter ruling specifies that all evidence should be considered, "including: service provider invoices; service provider attestation regarding the scope and timing of services; service provider engagement letters; board of director minutes; corporate and service provider meeting minutes and calendar entries; documents developed by the providers and presented to the board of directors; general ledger entries; financial statements; management agreement; flow of funds memo; wire transfer and other bank records; transaction documents; and Company's internal accounting information."¹⁴

Service Guidance and Directives

In an earlier directive to field agents, (LB&I-04-0511-012), LB&I examiners were directed not to challenge a taxpayer's treatment of success-based fees paid or incurred in a covered transaction in taxable years ended before April 8, 2011, when a taxpayer's original return position capitalized at least 30 percent of the total success-based fees incurred by the taxpayer with respect to the covered transaction. The earlier directive is consistent with the safe harbor guidance provided in Rev. Proc. 2011-29.¹⁵ Under this procedure, if a taxpayer pays or incurs a success-based fee while investigating or otherwise pursuing a covered transaction, a taxpayer may treat 70 percent of the success-based fee as an amount that does not facilitate the transaction. The remaining portion must be capitalized as an amount that facilitates the transaction. The election may be made for success-based fees paid or incurred in taxable years ending on or after April 8, 2011. Given the extensive documentation typically required by the Regulations, taxpayers sought clarification regarding the types of records necessary to support their deductions and to avoid burdensome recordkeeping requirements. Prior to issuing the revenue procedure, the Service regularly challenged the adequacy of substantiation in examinations.¹⁶ The safe harbor election was designed to minimize these disputes. Consequently, this guidance suggests that a significant portion of success fees may be deducted without being subject to the arduous documentation requirements.

To make the safe harbor election, the taxpayer must attach a statement to its return electing the safe harbor, identifying the covered transaction to which the election applies, and stating the success-based fee amounts that are deducted and capitalized. The election applies only to the transaction identified in the statement, and all success-based fees paid or incurred in that transaction are treated under the safe harbor. The safe harbor election is irrevocable once made.

When the safe harbor revenue procedure was issued, it provided welcomed simplification. However, a legal memo that was issued to clarify application of the safe harbor was somewhat perplexing because it minimized the simplification envisioned by the safe harbor. In CCA 201234027,¹⁷ the IRS National Office addressed the treatment of milestone payments made by taxpayers electing the safe harbor. The Service concluded that nonrefundable milestone payments made to a service provider in connection with a covered transaction are not success-based fees and thus do not qualify for the safe harbor. By refusing safe harbor treatment for milestone payments, the Service seemed to be giving with one hand while simultaneously taking away with the other. The safe harbor simplifies the determination of the proper tax treatment of success-based fees in the corporate transaction context. Unfortunately, however, because milestone payments are a regular part of corporate transactions, and frequently creditable to success-based fees, by finding that these payments were ineligible for the safe harbor, the Service dramatically reduced the beneficial effect of the safe harbor.

Updated Directive

The new directive seems to suggest a change in Service position because it directs Service Examining Agents not to examine the treatment of milestone payments if a taxpayer has elected the safe harbor provisions. Specifically, the directive defines a 'milestone payment' as "a non-refundable amount contingent on the achievement of a milestone. Any amount that would be paid or incurred even if the milestone is not achieved is not contingent on the achievement of a milestone and is, therefore, not includable in a milestone payment, notwithstanding that the parties' agreement may provide that such amount is creditable against or otherwise offsets the amount due on the milestone payment."¹⁸ The term, 'eligible milestone payment' is further described, for purposes of the directive, as "a milestone payment paid for investment banking services that is creditable against a success-based fee."¹⁹ The directive provides certain requirements for an LB&I agent's review of transaction costs for tax years both before and after the effective dates of the Rev. Proc. 2011-29.

For tax years ending on or after the date Rev. Proc. 2011-29 was issued, (April 8, 2011), agents are directed not to review milestone payments if three requirements are met. First, the taxpayer must have made a timely safe harbor election under Rev. Proc. 2011-29 with respect to a covered transaction. Second, the taxpayer deducted no more than 70 percent of any eligible milestone payment incurred in connection with the respective success-based fee on its original tax return for the year in which the liability for the eligible milestone payment accrued. Third, the taxpayer cannot be contesting its liability for the eligible milestone payment.

The directive acknowledges that when a covered transaction spans multiple years, a taxpayer may make eligible milestone payments in tax years preceding the year in which the success-based fee would be paid, and thus, the milestone payment may occur prior to a year when a safe harbor election could have been made under Rev. Proc. 2011-29. In those situations, agents may forgo examination if the taxpayer satisfies various requirements. Specifically, the taxpayer must have deducted no more than 70 percent of any eligible milestone payment on its original tax return for the year and may not be contesting liability for the eligible milestone payment. Further, the taxpayer must document, e.g., through books and records, that in the year the eligible milestone payments were made, the taxpayer intended to elect Rev. Proc. 2011-29 with regard to the respective success-based fee, and if the transaction successfully closed, the taxpayer must actually have elected the safe harbor under Rev. Proc. 2011-29 for the success-based fees that were paid or incurred.

For milestone payments incurred in a tax year prior to the effective date of Rev. Proc. 2011-29, the taxpayer may not have deducted more than 70 percent of any eligible milestone payment on its original tax return for the year when the liability for the payment accrued and the taxpayer may not be contesting its liability for the eligible milestone payment.

Analysis

The directive will likely be well received by companies undergoing corporate transactions. It makes clear that as a general rule, all investment banking fees, including success-based fees paid at closing as well as milestone payments that may be creditable to those success fees are eligible for the safe harbor election.

Unless and until additional guidance is issued, however, taxpayers face uncertainty regarding the proper treatment of transaction costs. Whenever a corporate transaction is completed, companies are required to carefully review advisory fees to determine the proper treatment of costs that may be quite significant. For companies completing a significant transaction, transaction cost review is essential as many transaction costs are incurred and generally 30-90 percent of advisory fees may be deducted or amortized. Because the safe harbor election is limited to success-based fees, this simplification measure is necessarily limited. Although Rev. Proc. 2011-29 and the directive provide relief and enhanced surety regarding certain success-based fees, additional Service guidance would also be appreciated.

A number of important transaction cost issues remain outstanding. With respect to the directive, how do companies demonstrate intent to elect the safe harbor? For example, in instances when a covered transaction spans multiple years, public companies may be able to point to a reserve and/or other documentation supporting financial accounting review, which could suggest this intent. But many companies may be left flat-footed without adequate support to delineate intent. The directive is clear that documents supporting this intention will be required in examination. Further, there is no guidance regarding the examination of non-investment banking success-based fees. It is not uncommon for other advisors, especially law firms and consulting firms, to charge success-based fees on significant corporate transactions. Because Rev. Proc. 2011-29 requires that the safe harbor is applicable to all success-based fees, it would appear that the Service finds some value in continuing to examine non-investment banking success-based fees, which were specifically excluded from the directive. However, it would seem inconsistent with the revenue procedure's conclusion that the Service will focus examination resources on such fees. The revenue procedure is clear that the Service will not disturb allocations that are made when the safe harbor is elected.²⁰ It seems incongruous with the revenue procedure that the Service would continue to examine such fees, however, the directive is explicitly limited to investment banking fees, suggesting continued review of other advisory fees. Some companies may find that this discrepancy means that audit firms may not allow recognition of deductions that they are otherwise entitled to under the revenue procedure.

Additionally, a distinctive lack of guidance remains for the use of simplifying conventions for non-covered transactions and/or fees that are not success-based fees. Thus, when a company incurs costs in a transaction that is not a covered transaction and/or such fees are not success-based, a detailed review would continue to be required. Further, the revenue procedure and related directive do not address whether amortizable fees are part of the 70 percent or the 30 percent component; how to determine whether costs should be treated as amortizable start-up expenditures or deductible business expansion costs; and whether the fees are properly taken into account by a particular taxpayer. This question - which taxpayer should take transaction costs into account - is especially important in transactions involving parent and subsidiary, (for example, in a consolidated setting and/or multinational companies.) Significant complications arise, with financial reporting, tax return preparation, and Service examination, because these issues have not been addressed by the Service.

While the safe harbor and related directive offer simplification, taxpayers should nonetheless analyze each transaction and associated success fees to confirm eligibility for the safe harbor and to analyze these issues. Electing the safe harbor without consideration of the subsidiary issues could result in harsh results that have permanent consequences. For this analysis, familiarity with the case law and Regulations regarding fee allocations can help taxpayers both evaluate the documentation burden for a deductibility position and determine whether the safe harbor is beneficial or underestimates its success-based fee deductions.

Footnotes

1. Success-based fees are defined to include a payment that is contingent on the successful closing of a "covered transaction." Covered transactions are described in Treas. Reg. §1.263(a)-5(e)(3) and include: (i) a taxable acquisition by the taxpayer of assets constituting a trade or business; (ii) a taxable acquisition of an ownership interest in a business entity if immediately after the acquisition, acquirer and the target are related within the meaning of I.R.C. §267(b) or §707(b); and (iii) a reorganization described in §368(a)(1)(A), (B), or (C), or a reorganization described in §368(a)(1)(D) in which stock or securities of the corporation to which the assets are transferred are distributed in a transaction qualifying under §354 or §356.

2. 2011-29, 2011-18 I.R.B. 746.

3. LB&I-04-0413-002, April 29, 2013.

4. August 24, 2012.

5. U.S. v. Gilmore, 372 U.S. 39, 49 (1963). Tech. Adv. Mem. 91-44-042 (July 1, 1991) ("Professional fees incurred during the course of an unsuccessful tender offer must be allocated based on the specific services performed to determine the proper treatment of the fees."); Priv. Ltr. Rul. 96-41-001 (May 31, 1996) ("The portion of the fees allocated to the consent solicitation is required to be capitalized and the portion allocated to the debt tender offer is an ordinary and necessary business expense."). Section 6110(j)(3) precludes taxpayers from using or citing private letter rulings or technical advice memoranda as precedent, because each ruling is directed only to the taxpayer that is the subject of the ruling. Although these rulings cannot be relied on as a precedent, they indicate the manner in which the Service has applied the law in somewhat similar circumstances.

6. 397 U.S. 572 (1970).

7. 119 F.3d 482, 491 (7th Cir. 1997).

8. 224 F.3d 874 (8th Cir. 2000).

9. 1999-1 C.B. 32.

10. Treas. Reg. §1.263(a)-5(e)(3).

11. See Treas. Reg. §§1.263(a)-5(e)(1)(ii)(2); (e)(1).

12. Treas. Reg. §1.263(a)-5(f).

13. Id.

14. Priv. Ltr. Rul. 2009-53-014 (Jan. 4, 2010).

15. 2011-18 I.R.B. 746.

16. Rev. Proc. 2011-29 notes that "numerous disagreements have arisen regarding the type and extent of documentation required."

17. August 24, 2012.

18. LB&I-04-0413-002, April 29, 2013.

19. Id.

20. Rev. Proc. 2011-29, 2011-18 I.R.B. 746.

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