Deductibility of target's professional fees in a hostile takeover.

As the Supreme Court was preparing to hear oral arguments in INDOPCO, Inc., Sup. Ct., 1992 (formerly National Starch & Chemical Corp., 93 TC 67 (1989), all'd, 918 F2d 426 (3d Cir. 1990)), on the deductibility of professional fees in a friendly takeover, the IRS attempted to further erode taxpayers' ability to deduct professional fees related to a takeover or tender offer, this time in a hostile takeover setting. In IRS Letter Ruling (TAM) 9144042, the Service invoked the long-term benefit test applied in National Starch to fees incurred in a hostile takeover, stating unequivocally that the nature of the takeover (hostile or friendly) is not determinative of the proper tax treatment of such fees.

In the technical advice memorandum, X received an unsolicited tender offer from Z to purchase approximately 45% of its common stock. To assess the terms and impact of the tender offer, X's board of directors engaged a team of investment bankers, attorneys and tax and media professionals. Relying on their advice, X's board of directors rejected the tender offer, and instituted steps to defend against a takeover. These steps included a counter-tender offer for Z's shares, a self-tender offer for X's own shares, and a judicial challenge of Z's credit agreement and Z's obligations under a consent agreement with X. After a temporary restraining order was imposed on Z's takeover attempt, X and Z entered into a settlement and standstill agreement under which X agreed to pay Z for the repurchase of X's stock, and to reimburse Z for amounts incurred in connection with the tender offer. X claimed that the board's actions were taken pursuant to its fiduciary responsibility to its shareholders and, therefore, the professional fees were deductible as ordinary and necessary expenses under Sec. 162.

The IRS stated that the nature of a proposed corporate takeover (i.e., friendly or hostile)was not determinative of the proper tax treatment for professional fee expenditures. Rather, the expenditures had to be analyzed to ascertain whether the target corporation obtained a resultant long-term benefit. Moreover, while the Service did not specifically reach a conclusion on the deductibility or nondeductibility of the fees, it placed the burden of proof on the taxpayer to demonstrate that it did not obtain a long-term benefit as a result of these expenditures. This requires the allocation of the professional fees to the various services performed and an analysis of whether the services resulted in a long-term benefit to the target.

The TAM also addressed the deductibility of costs incurred by X to repurchase its stock and to reimburse Z for its expenses in the attempted takeover. The IRS held these costs must be capitalized, rejecting X's argument that Five Star Mfg. Co., 355 F2d 724 (Sth Cir. 1966), applied with respect to the costs of the buy-back. National Starch and prior IRS view National Starch received a friendly takeover bid from Unilever in 1978. The company incurred investment banking fees (to evaluate the fairness of the proposal) and legal expenses (to advise its directors on their fiduciary duty and to structure the transaction). No hostile tender offer was received by National Starch and the transaction was completed as a friendly takeover. National Starch took the position that the investment-banking and legal fees were deductible as ordinary and necessary business expenses.

The Supreme Court affirmed the Tax Court and Third Circuit in holding that the expenses were nondeductible capital expenditures, as they were attributable to a transaction that created a long-term benefit to the target corporation. The Court ruled that deductions are exceptions to the normal rule that items are capitalized unless a deduction is otherwise provided by law. Furthermore, the taxpayer failed to demonstrate that the expenses were ordinary and necessary business expenses under Sec. 169,. The Court rejected the taxpayer's assertion that Lincoln Savings & Loan Ass'n, 403 US 345 (1971), stood for the proposition that the absence of a capital asset being created rendered the expenses deductible rather than capitalizable. Instead, the Court held that Lincoln Savings merely held that "the creation of a separate and

distinct asset may be a sufficient condition for classification as a capital expenditure [under Sec. 263], not that it is a prerequisite to such classification." The Court found it relevant to examine whether benefits were realized beyond the year in which the expenditure was incurred.

The Court found the factual record established by the lower courts had proven that the taxpayer realized a long-term benefit from the acquisition to which the expenditures related. National Starch and investment banker reports prepared contemporaneously with the acquisition had identified synergistic benefits from the business combination. Furthermore, National Starch management had viewed the act of going "private" as a wholly owned subsidiary of Unilever to be in the best interest of the company, with substantial shareholder-relation expenses incurred by a public corporation eliminated.

Before the issuance of Letter Ruling 9144042, it was generally believed that fees related to a hostile takeover were distinguishable and therefore deductible. The Service confirmed this belief in Letter Rulings (TAMs)9043003 and 9043004, both of which held that expenses incurred to resist a hostile takeover were deductible under Sec. 162. Although the IRS has not explicitly revoked these earlier TAMs, they no longer reflect the Service's position, as evidenced by Letter Ruling 9144042.

Tax planning 

The moral of the story is clear. With increased {RS scrutiny of professional fees related to merger/acquisition transactions, careful analysis and tax planning are required to support their deductibility. In light of the Supreme Court's focus on the presence of more than an incidental long-term benefit to the taxpayer in INDOPCO, the facts or circumstances of a hostile-versus-friendly offer may be distinguishable from those in that case. Letter Ruling 9144042 allows taxpayers to demonstrate that the services received for professional fees incurred in a takeover attempt do not provide a long-term benefit, and taxpayers that can make such a showing still have the opportunity to currently deduct such fees. (Note, however, that Sec. 162(k) which denies any deduction for certain expenses incurred in connection with a redemption of stock, may also be relevant.)

From P. Michael Baldasaro, CPA, New York, N.Y., and Lynn M. Morzorati, CPA, Washington, D.C.