United States

IRS expands the definition of eligible milestone payment

TAX ALERT  | 

In April 2011, the IRS issued Rev. Proc. 2011-29, which provides a safe harbor for allocating success-based fees paid or incurred in connection with certain covered transactions between facilitative and non-facilitative activities for tax years ending on or after April 8, 2011. In lieu of maintaining the documentation required by Reg. section 1.263(a)-5(f), Rev. Proc. 2011-29 authorizes the taxpayer to make an election on a timely filed original tax return to treat 70 percent of the success-based fees as amounts that do not facilitate the transaction. The remaining 30 percent of the fees must be capitalized as amounts that facilitate the transaction.

This safe harbor provided welcome guidance since without the election, a taxpayer must maintain documentation under Reg. section 1.263(a)-5(f) to rebut the presumption that all success-based fees paid are facilitative in nature. In the short time since the release of this revenue procedure, taxpayers have grappled with whether the safe harbor applies to milestone payments paid or incurred in the course of a covered transaction for which the taxpayer incurs a success-based fee.

On Jan. 27, 2014, the IRS Large Business & International Division (LB&I) issued an updated directive (LB&I-04-0114-001) instructing agents not to challenge the treatment of eligible milestone payments as part of the success-based fees to which the safe harbor applies. The new directive updates a prior directive by expanding the definition of a milestone to include any event, including the passage of time, occurring in the course of a covered transaction under Reg. section 1.263(a)-5(e)(3). Taxpayers currently incurring eligible milestone payments in connection with a covered transaction should discuss with their tax advisors whether they are eligible to apply the safe-harbor method to milestone payments incurred in tax years for which a return has not yet been filed.

The prior directive only applied to milestones occurred on or after the “bright-line” date, which is the date the decision to go through with the deal is ultimately made.1 Thus, the prior definition effectively limited the period of time within which an event could be considered a milestone.

The new directive expands the definition of a milestone to include any event, including the passage of time, occurring in the course of a covered transaction under Reg. section 1.263(a)-5(e)(3). Both directives effectively uphold a taxpayer’s application of the safe-harbor method of Rev. Proc. 2011-29 to certain nonrefundable milestone payments and represent a change in position from a chief counsel advice memorandum issued in 2012. In that memorandum, the IRS ruled that the safe-harbor election of Rev. Proc. 2011-29 does not apply to nonrefundable milestone payments that were creditable against a success-based fee incurred by the taxpayer in a covered transaction under Reg. section 1.263(a)-5(e)(3)2 (see Safe harbor treatment of eligible milestone payments).

Beyond the expansion of the definition of a milestone, the directive mirrors the language in the prior directive. Thus, the directive applies only to “eligible milestone payments” paid or incurred by an eligible taxpayer in a covered transaction under Reg. section 1.263(a)-5(e)(3) if the taxpayer meets the requirements set forth below. An eligible milestone payment is a non-refundable amount, contingent on the achievement of a milestone, paid for investment banking services and creditable against a success-based fee.

For taxable years ending on or after April 8, 2011

A taxpayer’s treatment of eligible milestone payments will not be challenged if the taxpayer:

  1. Qualified for and timely elected the Rev. Proc. 2011-29 safe harbor for the covered transaction
  2. Deducted no more than 70 percent of any eligible milestone payment incurred in connection with the respective success-based fee on its original tax return for the year in which the taxpayer’s liability for the eligible milestone payment accrued
  3. Is not contesting its liability for the eligible milestone payment

In instances where a covered transaction spans multiple tax years and eligible milestone payments were incurred prior to a year to which Rev. Proc. 2011-29 applies, the taxpayer’s treatment of the payment will not be challenged as long as the taxpayer:

  • Satisfies the requirements of (2) and (3) above
  • Has documented (e.g., in its books and records) that in the year in which the eligible milestone payments were made, it intended to elect the safe-harbor method for the respective success-based fee
  • If the transaction successfully closed, did in fact make the safe-harbor election for the success-based fee that was paid or incurred

For taxable years ended before April 8, 2011

A taxpayer’s treatment of its eligible milestone payment will not be challenged if the taxpayer’s return position meets the requirements of LB&I directive LB&I-04-0511-012 with regard to success-based fees paid or incurred in tax years ended before April 8, 2011, and the taxpayer satisfies requirements (2) and (3), above.

Implications

The directive not only upholds a taxpayer’s application of the safe-harbor method of Rev. Proc. 2011-29 to eligible milestone payments, but also effectively allows any event occurring in the course of a covered transaction to qualify as a milestone for purposes of determining whether a taxpayer has incurred an eligible milestone payment. This is welcome news for taxpayers with otherwise eligible payments that would not have qualified as a “milestone” payment under the previous directive. Taxpayers currently incurring eligible milestone payments in connection with a covered transaction should discuss with their tax advisors whether they are eligible to apply the safe-harbor method to milestone payments incurred in tax years for which a return has not yet been filed.

1. See Reg. section 1.263(a)-5(e)(1).

2. Reg. section 1.263(a)-5(e)(3) defines a covered transaction as one of the following: (1) a taxable acquisition by the taxpayer of assets that constitute a trade or business; (2) a taxable acquisition of an ownership interest in a business entity if, immediately after the acquisition, the acquirer and the target are related within the meaning of section 267(b) or 707(b); or (3) a reorganization described in section 368(a)(1)(A), (B), or (C), or a reorganization described in section 368(a)(1)(D) in which stock or securities of the corporation to which the assets are transferred are distributed in a transaction that qualifies under section 354 or 356.


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