Final regs. on capitalizing transaction costs.

The Service recently issued final regulations (TD 9107) under Sec. 263(a) addressing capitalization of amounts paid to facilitate certain types of acquisitive and capital transactions. The regulations are effective for amounts paid or incurred after Dec. 30, 2003 (although a taxpayer seeking to change an accounting method to comply with the regulations must make the change taking into account amounts paid or incurred in tax years ending after Jan. 23, 2002; see Borrack and Fitzpatrick, Tax Clinic, "Guidance on Accounting Method Changes for Intangibles," p. 330, this issue).

The regulations generally require a taxpayer to capitalize costs incurred in the process of "investigating or otherwise pursuing" one of several types of enumerated transactions. They also provide exceptions to the general rule, including a bright-line rule for costs incurred for certain types of acquisitive transactions, which replaces the facts-and-circumstances-based analysis of investigatory costs.

General Rule

Under Regs. Sec. 1.263(a)-5(a)(1)-(10), a taxpayer must capitalize costs incurred to facilitate any of the following transactions (applicable transactions):

* An acquisition of (1) assets constituting a trade or business and (2) stock in a corporation or ownership interest in another entity, if the acquirer owns 50% or more of such entity after the acquisition (specifically, if the acquisition results in a relationship described in Sec. 267(b) or 707(b)), for both acquirer and target costs;

* A restructuring, recapitalization or reorganization of capital structure (including Sec. 368 reorganizations and Sec. 355 distributions);

* A transfer under Sec. 351 or 721, for both transferor and transferee costs;

* A formation or an organization of a disregarded entity;

* A capital acquisition;

* A stock issuance or a borrowing; and

* The writing of an option.

According to Regs. Sec. 1.263(a)-5(b)(1), an amount "facilitates" an applicable transaction if a taxpayer incurs it while "investigating or otherwise pursuing" the transaction. This definition includes an amount paid to determine a transaction's price or value. According to the regulations, it is not a "but for" test per se, pursuant to which costs that would not have been incurred but for the transaction must be capitalized, although whether or not the transaction occurred but for the transaction is a relevant factor in determining whether a cost was paid to facilitate it.

Specific Types of Costs

Under Regs. Sec. 1.263(a)-5(c), certain costs do not facilitate an applicable transaction, including costs that facilitate:

* A borrowing;

* An asset sale (e.g., a disposition of unwanted assets before a merger);

* A stock distribution mandated by law, regulators or court order; and

* An integration of acquired businesses (regardless of when these activities occur).

Generally, costs incurred to institute and administer a bankruptcy proceeding are treated as facilitating a reorganization, according to Regs. Sec. 1.263(a)-5(c)(4). However, costs incurred to operate a business during a bankruptcy proceeding are not, nor are costs incurred to defend against an involuntary bankruptcy proceeding.

Under Regs. Sec. 1.263(a)-5(c)(8), amounts paid to terminate an applicable transaction to engage to another such transaction must be capitalized if the transactions are mutually exclusive.

Salaries, bonuses and commissions paid to employees in connection with an applicable transaction are not treated as facilitating a transaction, according to Regs. Sec. 1.263(a)-5(d)(1). Although annual director compensation does not facilitate a transaction, amounts paid to directors to attend special board meetings are not treated as employee compensation. Payments between consolidated group members are treated as employee compensation, as long as the services are provided when both are group members. Taxpayers may elect to treat employee compensation paid in the process of investigating or otherwise pursuing a transaction as facilitating the transaction (generally subject to capitalization).

Special Rule for Certain Acquisitive Transactions

Notwithstanding the inclusion of "investigating" in the general capitalization rule, the regulations provide an exception for costs incurred in certain types of acquisitive transactions, which is roughly equivalent to the exception for pre-decisional investigatory costs described in Wells Fargo & Co., 224 F3d 874 (8th Cir. 2000).The exception provided, however, in Regs. Sec. 1.263(a)-5(e) replaces the case law's facts-and-circumstances analysis with a more objective approach, providing that costs incurred in connection with certain types of transactions will not be treated as facilitative if they are (1) incurred before certain points in the transaction's timeline (the bright-line rule) and (2) not on a list of "inherently facilitative" costs (described below).

According to Regs. Sec. 1.263(a)-5(e)(3), this exception applies to certain costs incurred in particular types of acquisitions. Specifically, it applies to (1) an acquirer's costs in a taxable acquisition of assets that constitute a trade or business; (2) an acquirer's or a target's costs in a taxable acquisition of an ownership interest in a business entity (if, immediately after the acquisition, the acquirer and target are related under Sec. 267(b) or 707(b)); and (3) an acquirer's or a target's costs in an acquisitive reorganization under Sec. 368(a) (i.e., a reorganization under Sec. 368(a)(1)(A), (B), (C) or (D) (if the latter involves a distribution under Sec. 354 or 356)) (acquisitive transactions).

Bright-line rule: Costs incurred in connection with an acquisitive transaction (other than inherently facilitative costs) will not be treated as facilitating the acquisition if incurred on or before the earlier of the date on which:

* Both the acquirer and the target execute a letter of intent, exclusivity agreement or similar written communication (but not a confidentiality agreement); or

* The taxpayer's board of directors (or committee thereof) or, if the taxpayer is not a corporation, its appropriate governing officials, authorize or approve the transaction's material terms; if no such authorization is required, then the date on which the acquirer and target execute a binding agreement on the transaction.

"Inherently facilitative" costs: Costs listed as "inherently facilitative" are not subject to this exception and must be capitalized, no matter when incurred. According to Regs. Sec. 1.263(a)-5(e)(2), these costs are those paid for securing an appraisal or fairness opinion for a transaction, structuring a transaction (including negotiations and tax advice), preparing and reviewing a merger agreement or other transaction documents, obtaining regulatory or shareholder approval and conveying property between the parties (e.g., transfer taxes).

Documentation

Regs. Sec. 1.263(a)-5(f) provides rules on documenting success-based fees (i.e., fees contingent on closing a transaction, general]y for investment banking services). These fees are deemed to facilitate a transaction, except to the extent documentation establishes that a portion of a lee is allocable to activities that do not. Importantly, this documentation must be completed by the due date of a taxpayer's timely filed original return (including extensions) for the tax year in which a transaction closes. The regulations envision more than a mere summary of time and costs, requiring documentation consisting of supporting records that identify the activities performed, the fee amount (or percentage of time) allocable to each activity, the date of the activity (when relevant) and contact reformation for the service provider.

Treatment of Capitalized Costs

Under Regs. Sec. 1.263(a)-5(g)(2), an amount that is capitalized by the acquirer in a taxable stock or asset acquisition is added to the basis of the acquired stock or assets, while amounts capitalized by a target in a taxable asset sale reduce the target's amount realized on the disposition. The regulations do not address how to treat capitalized amounts requiring capitalization to other transactions to which they apply (e.g., tax-free transactions, a target's costs in a taxable stock acquisition and stock issuance costs). The preamble states that the Service and Treasury intend to issue separate guidance to address the treatment of these amounts and will consider whether such amounts should be eligible for the 15-year safe harbor amortization. In Notice 2004-18, the Service stated its intent to propose regulations that address the treatment of capitalized costs that facilitate a broad array of transactions, including those covered by the regulations.

Summary

The regulations attempt to impose some objective rules in an area of significant uncertainty. They are more and less taxpayer favorable than the case law they replace. The bright-line exception for acquisitive acquisitions is somewhat more restrictive than the facts-and-circumstances test, as applied by most taxpayers before the regulations. On the other hand, the regulations give some taxpayer-favorable results (e.g., as to internal salaries and bonuses). In any case, they should reduce the resources expended by both taxpayers and the government in analyzing how to treat transaction costs.

David Madden, J.D., LL.M.

Principal

Washington National Tax Service

KPMG LLP 

Washington, DC

FROM HARVEY BRAVERMAN, J.D., LL.M., AND JOHN GERACIMOS, J.D., WASHINGTON, DC