Documenting deductions for investment banking fees.

The Supreme Court's decision in INDOPCO, Inc., 503 US 79 (1992), held that fees for professional services (including investment banking services) incurred to facilitate a corporate acquisition have to be capitalized, because they produce a long-term benefit. However, the later decision in A.E. Staley Mfg. Co., 119 F3d 482 (7th Cir. 1997), clarified that investment banking fees paid in a successful merger transaction could be bifurcated into deductible and non-deductible components based on the nature of the underlying services. This division was allowed even though the investment banking fee was only to be paid on the merger's successful closing.

Sec. 263 Final Regs.

The bifurcation of investment banking fees has been a common practice in business acquisitions and was ultimately accepted in final regulations issued under Sec. 263. These rules provide guidance for capitalizing costs related to business acquisitions; generally, Regs. Sec. 1.263(a)-5(a) provides that costs incurred after a formal decision is made to pursue a transaction are facilitative and must be capitalized. Costs incurred before such date are generally deemed to be investigatory and, thus, deductible, subject to the special rule described below.

"Inherently Facilitative Amounts"

Regs. Sec. 1.263(a)-5(e)(2) provides an exception to the deductibility rule described above for "inherently facilitative amounts." Costs deemed to be inherently facilitative to a transaction are required to be capitalized, regardless of when incurred in the corporate acquisition timeline. These costs include professional or other fees incurred to structure the proposed transaction, to obtain regulatory or shareholder approval and to secure an appraisal, written evaluation or fairness opinion related to the transaction.

Success-Based Fees

Regs. Sec. 1.263(a)-5(f) specifies how the deductible portion of success-based fees (such as transaction-based investment banking fees) must be documented. This guidance imposes certain requirements on the nature and timing of the information supporting the deduction.

Required documentation: Regs. Sec. 1.263(a)-5(f) cautions that the support must consist of more than "merely an allocation between activities that facilitate the transaction and activities that do not facilitate the transaction, and must consist of supporting records (for example, time records, itemized invoices, or other records).... "These records must generally describe the activities performed by the investment banker, the portion of the fee allocable to each of these activities and the investment banker's name, business address and phone number.

However, the fact that "mere allocations" are unacceptable does not mean that other forms of allocation are unacceptable. As indicated in Regs. Sec. 1.263(a)-5(f)(2), allocating the fees based on the actual services provided or to certain activities based on a percentage of time spent, is clearly acceptable. In making these allocations, taxpayers are required to conduct a detailed analysis of the various activities the investment bankers performed and to gather supporting records.

Timing: Regs. Sec. 1.263(a)-5(f) requires that such documentation be completed by the due date of the taxpayer's timely filed original Federal income tax return (including extensions) for the tax year in which the transaction closes. As a result, amending a previously filed return after the original due date (including extensions), based on information subsequently obtained, is not acceptable.

Applying the Rules

Investment bankers are often compensated under a success-based fee arrangement when a business is sold or acquired. In addition, a separate amount is sometimes charged for the issuance of a fairness opinion. If separately stated, the treatment of a fairness opinion fee is relatively straightforward--it is capitalized in its entirety as an inherently facilitative cost if the transaction is ultimately consummated. However, the determination of the deductible portion of a success-based fee requires some analysis of the activities the investment bankers performed.

Practical problems: While the guidance provided in Regs. Sec. 1.263(a)5(f) for documenting the deductible portion of success-based fees appears relatively simple, applying it in practice may pose some unforeseen difficulties. The investment banking industry has not historically maintained detailed time and expense records allocated to the specific phases of an engagement. Thus, creating the detailed supporting records referred to in the regulations may be difficult--if not impossible--for some transactions, especially for those already significantly under way when the final regulations became effective (Dec. 31, 2003).

While the regulations do not permit mere allocations between deductible and nondeductible amounts, it remains to be seen whether Treasury will accept allocations made by the investment bankers themselves to the various services they provided, based on informed recollections of the course of the engagement, even though such allocations may not be supported by time and expense records. If done properly and in good faith, these allocations should be acceptable, as there is no requirement that the supporting records consist of time and expense detail--such detail is merely a suggested example of acceptable support. Regs. Sec. 1.263(a)-5(f) does allow for "other records" to be used as support for the determination of the deductible portion of the overall success--based fee.

Strategy: Going forward, it will be essential for taxpayers to initiate discussions with investment bankers early on in a potential business acquisition. While taxpayers should consider requesting their investment bankers to maintain time and expense records pertaining to a particular transaction, alternative support should be sought if this information will not be available. For example, frequent interviews and discussions with the investment bankers throughout the various stages of the engagement will likely enable a taxpayer to build an acceptable file of supporting documentation as to the deductible portion of the investment banking fee.

Conclusion

Regs. Sec. 1.263(a)-5 confirms that success-based investment banking fees can be bifurcated into deductible and nondeductible components based on the nature and timing of the various services provided. However, the rifles for documenting these deductions may be difficult to apply in practice, because they may require detailed information that investment bankers have historically not maintained. Taxpayers and tax advisers involved in success-based fee arrangements with investment banking firms must begin communicating earlier and more frequently, so that tax documentation requirements can be adequately addressed in the early stages of the investment banking relationship.

From David A. Thornton, CPA, Columbus, OH