Are takeover fees deductible?

ARE TAKEOVER FEES DEDUCTIBLE?

Nowadays, the possibility exists that almost any corporation can be the subject of a takeover. Companies thought to be secure and well run, with stable corporate cultures, may find themselves in danger of being controlled by individuals whose philosophies and methods of operation differ tremendously from those of the corporations.

Faced with a takeover, management usually has two alternatives. Either it can work with the individuals seeking to take over the company to fashion some sort of satisfactory arrangement, or it can try to find an alternative buyer whose philosophy matches its own.

Neither course of action is simple. Either one may require extensive financial, technical and legal assistance, and the expenditure of large sums of money to fund the actions chosen.

The Internal Revenue Service and the Tax Court have now added to the uncertainty with recent pronouncements. The service ruled that the expenses incurred in opposing a hostile takeover were deductible, while the court disallowed such costs' deductibility in the context of a friendly takeover.

THE SERVICE'S VIEW

In Technical Advice Memorandum 8927005, a corporation was the subject of takeover action. The company's board of directors did not find this action in the company's best interests. Because the acquiring corporation's financial condition was highly leveraged, and such a circumstance could have damaged the company's capital and surplus positions, the company hired a firm to oppose the takeover. Ultimately, the firm was able to find an alternative buyer for the company, one whose strategic business plan and outlook were more compatible with the company's than those of the first buyer.

In allowing a deduction for the costs of opposing the takeover, the IRS concluded the costs were ordinary and necessary business expenses: They were incurred in protecting the company's and the shareholders' interests against the (perceived) harm that would have resulted from the takeover.

THE TAX COURT'S VIEW

Compare that ruling to the decision in National Starch and Chemical Corporation, 93 TC no. 7. In the second case, a holding company indicated an interest in acquiring all the stock of National Starch. A law firm was called in to structure an arrangement that would satisfy National Starch's largest shareholder; he would dispose of his stock only if the transaction was tax-free and available to all the shareholders.

Once such an agreement had been arranged, National Starch hired an investment banking firm to evaluate the offer, provide a fairness opinion and assist in the event of any hostile tender offers. This firm charged National Starch a fee for its services, which the company deducted as a business expense.

Rather than examining the "ordinary and necessary" aspect of these costs, the court instead focused on whether they produced a benefit extending beyond the current year, which therefore would be capital expenditures. Because the ownership change was in the long-term interests of the company and its shareholders, the resulting costs were capital in nature, benefiting the corporation's operation for the duration of its existence or for an indefinite time (that is, a time somewhat longer than the current tax year). This was true even though the costs did not result in the creation or enhancement of a separate identifiable asset.

ANALYSIS

Obviously, the major difference in these two situations is that, in the IRS ruling, the costs were incurred in connection with a hostile offer, while the offer made to National Starch was friendly. However, neither the service nor the court implied this distinction provided a basis for the differences in their conclusions. Both focused on the dominant purpose for each expenditure. However, the IRS more closely examined the "ordinary and necessary" nature of the costs (simply stating the expenses did not result in the creation of a capital asset), while the court more closely analyzed the continuing nature of the benefit gained.

SUMMARY

This area is one of continuing importance, as the number of takeovers (and takeover attempts) continues to be significant. And it is clear that these two decisions will result in much confusion. While the Tax Court's analysis seems to be more extensive and better-reasoned, the IRS's conclusions do give some indication of its approach to this issue and may provide the basis for successful argument.

For a discussion of this and other recent development, see the Tax Clinic, edited by Howard Siegel, in the December 1989 issue of The Tax Adviser.

Nicholas J. Fiore, editor

The Tax Adviser