Takeover expenses: National Starch and the IRS add new wrinkles.

In the 1980s, the business world witnessed a proliferation of mergers and acquisitions. Of transactions valued at $1 million or more, over 31,000 M&As involving U.S. companies occurred during the last decade, with a total value exceeding $1.34 trillion. Although the number of M&As appears to be declining, the dollar value of transactions in which public companies are targeted for takeover continues to increase. Given takeovers' volume and magnitude and the tax dollars at stake, the Internal Revenue Service is paying particular attention to takeover-related expenses.

For the acquiring company, the rules for the proper tax treatment of M&A costs are reasonably clear--generally the costs are nondeductible capital expenditures. However, because much uncertainty surrounds the tax treatment of the acquired or target company's expenses, careful planning is necessary. This article examines the evolution of tax rules for a target company's costs during a hostile or friendly takeover. Strategies to maximize current deductions also are suggested. (See exhibit 1, page 90, for a summary of the evolution of corporate takeovers. A glossary of takeover terms appears on page 92. )

HOSTILE TAKEOVERS, WHITE KNIGHTS AND RELATED EXPENSES

A takeover attempt opposed by the target company's management or board of directors is a hostile or unfriendly takeover. Typically, the acquiring company makes a tender offer to buy shares in the target company from some or all of the latter's shareholders. If the target's board determines a takeover is not in shareholders' best interests, defensive measures generally are taken, possibly including the search for a white knight.

The target company incurs expenses to evaluate a tender offer. Directors often retain an investment banking firm to value the stock and issue a fairness opinion. Also, the directors typically retain legal counsel. If the board decides to resist the takeover, it incurs expenses for defensive actions. Exhibit 2, page 93, summarizes this process.

The central tax issue is whether the costs of defending against a hostile takeover or facilitating a white knight acquisition are deductible. Under Internal Revenue Code section 162, a deduction is allowed for all ordinary and necessary expenses incurred in carrying on a trade or business. "Ordinary" is not defined in the statutes and is left to judicial interpretation.

In Welch v. Helvering [290 US 111 (1933)], the U.S. Supreme Court concluded expenses common to a particular industry or line of business are ordinary. Moreover, such expenses need not be habitual or recurring to be considered common. Thus, an expense occurring only once in the taxpayer's life nevertheless may be an ordinary business expense. The costs of a proxy contest to protect corporate policy, for example, were deductible as ordinary business expenses in Locke Manufacturing Companies v. United States [237 F. Supp. 80 (DC Conn. 1964)]. The district court said proxy contests had become a "standard or norm of conduct" and thus were ordinary. Commissioner v. Tellier [383 US 687 (1966)] further refined the definition of ordinary. In Tellier, the Supreme Court said the principal function of "ordinary" in section 162 is to distinguish between currently deductible expenses and nondeductible capital expenditures.

PRE-1989 ADMINISTRATIVE PRONOUNCEMENTS

The IRS issued revenue ruling 67-1 to announce it would follow the decision in Locke Manufacturing on deductibility of corporate proxy fight expenditures. However, deductions for such expenses were allowed only if incurred to protect corporate policy. Corporate proxy contest expenditures "primarily for the benefit of the interests of individuals" still were not deductible. The ruling's language suggested the expenditures would be disallowed only if they were preferential dividends to stockholders or excessive compensation to officers-stockholders.

A subsequent pronouncement, revenue ruling 67-125, established the "alteration of capital structure" rule, based on the proposition any expenditure related to a change in a corporation's capital structure must be capitalized. Thus, legal fees to obtain advice about a proposed merger, a stock split or a stock redemption are incurred as part of a change in the surviving corporation's capital structure and are not deductible. The ruling maintained, however, that if the proposed change in structure did not materialize, legal fees would be deductible in the year the proposal was abandoned. Arguably, under this theory legal fees for an aborted merger also are deductible.

Revenue ruling 69-561 revisited deductibility of expenditures related to a change in capital structure. The IRS ruled brokerage fees a corporation paid to repurchase shares of its own capital stock were not deductible as ordinary and necessary business expenses. Repurchase costs were held to be part of the purchase price the corporation paid for the stock.

In a subsequent technical advice memorandum, TAM 8516002, the IRS considered the deductibility of expenses to oppose a tender offer. The IRS held

* Litigation costs to resist the tender offer were deductible. They relied on Tellier, in which litigation expenses in a business context were found to be deductible.

* Costs incurred in an. unsuccessful search for a white knight were deductible in the year the search was abandoned.

* Costs associated with informing stockholders of management's opposition to a tender offer also were deductible. Because the expenses arose from the corporation's efforts to protect corporate policy, the expenses were not primarily for the shareholders' benefit.

* Payments to a corporate officer for redemption of stock options were deductible as compensation for services, contrary to revenue ruling 69-561. Thus, the IRS determined all the costs incurred to defend against a hostile takeover were deductible as ordinary and necessary business expenses.

Less than a year after deciding the costs of fighting a hostile takeover should be deductible as ordinary and necessary business expenses, the IRS again reversed its position with TAM 8626001. In addition to withdrawing TAM 8516002, TAM 8626001 specifically considered the treatment of greenmail payments. The IRS held redemption of a corporation's own stock was a capital expenditure, and no deduction was allowed. The IRS said the fact the repurchase arises from a shareholder dispute has no bearing on deductibility.

NATIONAL STARCH (indopco) CASE

In a case of first impression, the Tax Court held costs incurred by a target company in a friendly merger were nondeductible capital expenditures [National Starch and Chemical Corporation v. Commissioner, 93 TC 67(1989)]. The Third Circuit Court of Appeals concluded the Tax Court findings were not clearly erroneous and affirmed the decision [National Starch and Chemical Corporation v. Commissioner, 918 F.2d 426 (1990)]. In a unanimous decision, the U.S. Supreme Court upheld the lower court decision that costs incurred in a friendly merger were not deductible for federal tax purposes (INDOPCO, Inc. v. Commissioner, 1992 Lexis 1374). Note: Before the Court decision, National Starch changed its name to INDOPCO, Inc.

Background. National Starch was approached by Unilever United States, Inc., one of its suppliers, about a friendly takeover by Unilever. A major stockholder and member of the board agreed he and his wife would relinquish their 14.5% holding in National Starch if the takeover could be structured as a tax-free transaction, thereby meeting their estate planning goals.

To accommodate these shareholders, the takeover was structured as a subsidiary cash merger, in which Unilever created a subsidiary to acquire National Starch's outstanding shares in exchange for either cash or shares in the new subsidiary. This arrangement received a favorable ruling from the IRS; shareholders exchanging National Starch's shares for the new subsidiary's shares would incur no tax liability.

In fairness to its shareholders and in view of the board's fiduciary duty, National Starch engaged investment bankers to appraise the value of the stock involved in the transaction. Specifically, the bankers were engaged to conduct a preliminary analysis and examine alternatives available to National Starch. They also were to make a valuation judgment, give a fairness opinion and coordinate the merger's technical details. In addition, National Starch incurred legal expenses, Securities and Exchange Commission fees and shareholder proxy solicitation costs.

On its tax return, National Starch treated the investment banking fee (over $2.2 million) as a deductible business expense. The IRS disallowed the deduction on the basis the expenditure created a long-term benefit and must be capitalized. National Starch filed a petition (1989) in the Tax Court contesting the disallowance. It also claimed a refund for overpaid taxes, maintaining 'it had mistakenly failed to claim deductions for other merger-related expenses (about $706,000).

The argument. In arguing for deductibility before the Third Circuit (1990), National Starch relied on Commissioner v. Lincoln Savings & Loan Ass'n [403 US 345 (1971)]. In Lincoln Savings, the U.S. Supreme Court held additional premiums required by federal statute to be paid to the Federal Savings & Loan Insurance Corp. by the S&L were capital in nature because they created or enhanced a separate asset. National Starch maintained that, since its merger-related expenditures did not create a new asset or enhance an existing one, they were not capital costs but, rather, deductible business expenses.

In disallowing all takeover-related expenses, INDOPCO addressed whether the costs were deductible as ordinary business expenses or whether they were capital expenditures. It rejected National Starch's argument Lincoln Savings created a new "bright line" test for distinguishing deductible expenses from nondeductible capital expenditures. Although the U.S. Supreme Court agreed payments to create or enhance a separate asset are capital expenditures, it said its Lincoln Savings decision did not explicitly require creating or enhancing a separate asset as a necessary condition of capitalization.

In INDOPCO, the U.S. Supreme Court said the lack of a separate asset does not necessarily preclude applying the long-term benefit test. It conceded National Starch's expenses gave rise to neither a separate tangible asset nor a readily identifiable intangible asset. The Court concluded, however, the long-term benefit test did apply and, based on specific statements by National Staroh's management, the costs incurred in the Unilever merger served National Staroh's long-term betterment.

The takeover made Unilever's enormous resources, particularly its basic technology, available. Taking National Starch private also reduced shareholder-related expenses such as reporting and disclosure requirements, proxy fights and derivative actions. Administrative advantages resulted from eliminating unissued shares of stock and reducing the number of authorized shares. For these reasons, the costs incurred were held nondeductible capital expenditures.

FURTHER IRS PRONOUNCEMENTS

Just before the Tax Court ruling in National Starch, the IRS issued TAM 8927005, declaring costs of defending against a hostile takeover deductible as ordinary and necessary business expenses. A target corporation arranged to be acquired by a white knight as a hostile takeover defense. The target's board believed a merger with the hostile suitor company would be detrimental to its future financial success and to minority shareholders. Consequently, the corporation maintained the costs were incurred to enable the board of directors to carry out its fiduciary duties to shareholders.

As a result of the Tax Court holding in National Starch, the IRS issued TAM 8945003, rescinding TAM 8927005 regarding deductibility of costs to fight a hostile takeover. Maintaining its earlier analysis and conclusion was inconsistent with National Starch, the IRS expanded the scope of National Starch to include expenses to resist hostile takeovers. The IRS said, whether costs relate to a friendly merger or to resisting a hostile takeover, the long-term benefit test required the expenditures to be capitalized. Therefore, no deductions were allowed for merger costs, even if such merger was to protect the company from a hostile takeover.

The IRS, apparently deciding it had interpreted National Starch too broadly, again refined its position. TAM 9043003 allows deductibility to the extent expenses can be shown to relate to resisting a hostile takeover as opposed to facilitating a friendly one. Specifically, the IRS said a corporation's costs to resist a hostile takeover were deductible as ordinary and necessary business expenses. However, costs of either a merger or sale of stock to another corporation must be treated as nonamortizable expenses. Whether the merger or sale of stock was part of a strategy to prevent an unfriendly takeover was not a consideration in determining tax deductibility. Thus, costs of finding a white knight must be capitalized.

TAM 9043003 cites E.I. duPont deNemours and Company v. United States [432 F.2d 1052 (CA-3, 1970)], which says the permanency of the work accomplished by the expenditure must be considered in determining whether a deduction is allowed. Since a merger with a white knight not only protects against a hostile takeover (the permanency aspect) but also provides a long-term benefit, such a merger's costs must be capitalized. The IRS cautioned that the responsibility falls on the corporation to provide convincing evidence of expenditures associated exclusively with resisting a hostile takeover.

"In yet another reconsideration of its position the IRS issued TAM 9144042. tHIS ruling says deductibility of takeover-related professional fees does not turn on whether the takeover attempt is friendly or hostile. Instead, the key is whether the expenses result in a long-term benefit to the taxpayer, which bears the burden of demonstrating they don't.

PLANNING FOR DEDUCTIBILITY

Careful planning is necessary when a company incurs expenses to resist a hostile takeover while implementing a friendly acquisition. Taxpayers must be prepared to provide evidence of the expenditures' nature and should request itemized bills from investment bankers and legal advisers distinguishing between expenses to resist an undesirable suitor and those to encourage a white knight.

However, taxpayers should not place undue reliance on the IRS's current thinking on hostile takeovers as found in TAM 9144042. The IRS has displayed some lack of consistency on this admittedly difficult issue. Since TAMs have no precedential authority, they are not binding in a court of law. Thus, the IRS could modify its position when the deductibility of takeover-related expenses arises again.

Expenses of a friendly takeover that never happens, a situation not present in National Starch, should be deductible. If overtures from five suitors are rejected, but a sixth succeeds in a friendly takeover, expenses incurred in the first five takeover proposals should be deductible under the long-term benefit rule because no future benefit accrues from them. Only costs of the completed takeover are properly considered nondeductible capital expenditures.

The target company must carefully document all expenses from multiple overtures so those associated with abandoned attempts can be differentiated from those facilitating a successful takeover. Furthermore, assigning expenses to particular takeover attempts involves issues for which there is scant guidance. Nonrepetitive expenses, such as those for the initial valuation of stock, present opportunities for maximizing deductions to the extent they relate to aborted overtures.

COMPLEX RULES

M&As continue to be familiar events in the United States. Along with the increased complexity of takeovers and the size of the companies involved, taxpayers can anticipate a corresponding increase in the number and complexity of IRS rules. Moreover, as transactions become more involved, the distinction between defensive actions to fend off a hostile suitor-and actions to facilitate a friendly takeover becomes blurred. Consequently, correct application of the tax rules may be unclear. This confusion cannot be laid to rest until Congress or the courts provide additional stability by ironing out the wrinkles in the tax law with more definitive rules.

EVELYN C. HUME, PhD, is assistant professor of accounting, Georgia State University, Atlanta. She is a member of the American Accounting Association and the American Taxation Association. ERNEST R. LARKINS, PhD, is associate professor of accounting, Georgia State University, Atlanta. He is a member of the AAA and the ATA.

EXECUTIVE SUMMARY

* EVEN AS THE NUMBER of corporate takeovers declines, the IRS continues to scrutinize the deductibility of takeover-related expenses. For the acquiring company, takeover costs are nondeductible capital expenditures. But there is considerable uncertainty about the deductibility of expenses the target company incurs.

* THE CENTRAL TAX ISSUE is whether the costs of defending against a hostile takeover or facilitating a friendly acquisition are deductible. IRC section 162 allows a deduction for ordinary and necessary business expenses. However, the statutes don't define "ordinary," leaving it to the courts.

* SINCE THE LATE 1960s, the IRS has issued numerous rulings on deductibility of takeover-related expenses. Generally, the key factor is whether the expense results in a long-term benefit to the taxpayer. If so, the expenses must be capitalized.

* A KEY CASE IN determining deductibility is National Starch, also known as INDOPCO. The U.S. Supreme Court upheld the lower court ruling that friendly takeover costs are not deductible for federal tax purposes. The expenses were nondeductible capital expenditures.

* CAREFUL PLANNING is necessary to ensure deductibility of takeover-related expenses. When costs are incurred both to resist a hostile takeover and facilitate a friendly one, the taxpayer must be prepared to differentiate between the two, since only the former are deductible.

GLOSSARY OF TAKEOVER TERMS

Fairness opinion. A professional opinion, usually rendered by an investment banking firm, that the conditions of a proposed merger are within a range of prices informed parties would consider fair or reasonable.

Greenmail payments. Payments made to a hostile suitor by the target company to buy back shares of its own stock. IRC section 5881 imposes a 50% excise tax on receipt of greenmail payments.

Hostile takeover. An acquisition opposed by the target company's management or board of directors.

Proxy. An authorization to act on behalf of others in corporate matters, such as voting.

Proxy fight or battle. Battle between a company and its shareholders in which dissident shareholders solicit proxies to bring about a shareholder resolution.

Raider. The company attempting a hostile takeover of the target company.

Suitor company. The company attempting a takeover of the target company; the acquiring company.

Target company. The company a suitor company is attempting to take over; the acquired company.

Tender offer. Offer by a suitor company to buy the shares of a target company.

White knight. A friendly company that acquires a target company to prevent its takeover by a hostile suitor.