IRS proposal draws a line in the sand on allocation of certain M&A costs
TAX ALERT |
On March 5, 2015, the Treasury and the IRS issued proposed regulations addressing the allocation of merger and acquisition (M&A) costs when joining a consolidated tax filing. Specifically, the proposed guidance significantly limits the application of the next-day rule for success-based fees and similar costs.
In most M&A transactions, success-based fees paid to an investment banker or private equity management company and compensation payments (e.g., option cancellation payments and transaction bonuses) make up the lion's share of transaction-related expenses, which potentially provide a significant tax benefit to the party claiming the deductions. Historically, depending upon the tax position of the target (T) and purchaser (P) and when P and T will file a consolidated return after the acquisition, the timing of the deductions as pre- or post-transaction has been an item of negotiation between the parties. In particular, where there is a benefit to taking the deductions post-transaction, P may seek to gain agreement with T to claim the deductions post-transaction. Taxpayers and advisors have looked to the current next-day rule in the consolidated tax return regulations to provide this flexibility. Through taxpayer-unfavorable changes to the next-day rule, the proposed regulations, using a sledgehammer rather than a scalpel, would all but completely eliminate that flexibility without regard to specific factual issues, such as who bears the burden of the costs and who satisfies the costs.
The next-day rule
Under the consolidated return regulations, if a company (referred to as S in the consolidated return regulations, but referred to herein as T, as the company is often the target of an acquisition) becomes a member of a consolidated group during a consolidated return year, it becomes a member of the group at the end of the day that it becomes a member, and its short period tax year ends at the end of that day (the "end-of-day" rule).  As a result of the end-of-day rule, all items of income, deduction, gain or loss occurring on the day T joins the group are taken into account on its short-period return for the tax period ending before it joins the consolidated group.
The next-day rule, as currently written, is an exception to the end-of-day rule and applies when, on the day T joins the group, a transaction occurs that is properly allocable to the portion of the day after joining the group.  In such case, the item of income, gain, loss or deduction is taken into account by T for the period after joining the group.
The current regulations further provide that an item is properly allocable and allowable on the next day if it is (1) reasonable, and (2) consistently applied by all effected. More specifically, in determining whether an allocation of a transaction to the "next day" is reasonable, the following factors, however vague, are considered:
- Whether income or losses are allocated inconsistently
- If the item is from a transaction with respect to the new consolidated member's stock
- Whether the allocation is inconsistent with other requirements under the Internal Revenue Code, such as a section 338 election or a cancellation of debt situation under section 108
- Whether other facts exist to show that the transaction is not properly allocable to the next day, such as a prearranged transaction to arrive at an intended result 
For example, as discussed briefly above, taxpayers have sought to apply the next-day rule to success-based fees and compensation payments (e.g., option cancellation payments and transaction bonuses) that become due and payable upon successful closing of a transaction giving rise to T joining the group. The Treasury and the IRS, however, concluded that taxpayers were inappropriately applying the next-day rule in these cases. The Office of Chief Counsel in 2005 issued a technical advice memorandum  (TAM) noting this position and more recently issued general legal advice memorandum (GLAM) 2012-010 specifying its position that the next-day rule did not apply to, amongst other things, success-based fees and option cancellation payments.  Notwithstanding the TAM or the GLAM, many practitioners have continued to apply the next-day rule as they felt the TAM and GLAM were not an appropriate interpretation of the regulations. To that end, by applying the next-day rule to success-based fees and certain compensation-related items, the deduction arising from these costs has often been taken in the post-transaction period, a position the IRS felt did not result in a clear reflection of income.
As a result, in order to eliminate any uncertainty, the Treasury and the IRS have issued guidance in the form of proposed regulations that, if finalized, will represent binding guidance of the same authority as the Internal Revenue Code.
These proposed regulations establish a new "proposed next-day rule" that would only apply to an extraordinary item that is the result of a transaction that (1) occurs on the day T joins the group, but after the event resulting in T joining the group, and (2) would be taken into account by T on that day. Specifically, the proposed next-day rule has two very noteworthy changes. First, it would only apply to items arising after the transaction and would not apply to items that arise simultaneously with the events causing T to join the group. Second, this rule would now be mandatory and not elective.
To illustrate the rule, the proposed regulations provide a myriad of examples, three of which are worth mentioning:
- Success-based fees: The liability to pay success-based fees incurred upon closing of a stock acquisition is an extraordinary item that arose simultaneously with the acquisition and, therefore, must be reported under the end-of-day rule and included in the T short period return.
- Stock options: The liability to pay employees for the cancellation of stock options that became due as a result of a stock acquisition is an extraordinary item that must be allocated to the date T joins the group. The liability for this item arose simultaneously with the acquisition and, therefore, the proposed next-day rule is inapplicable.
- Unwanted assets: After the closing of a transaction where T joins a new consolidated group, T sells unwanted assets to an unrelated party. The gain or loss on the sale is an extraordinary item resulting from the transaction that occurs on the day T joins the group, but after the event resulting in T joining the group. Therefore, the gain or loss is reported on the post-transaction consolidated group return.
The proposed regulations clarify the current anti-avoidance rule, adding that it may apply to situations in which a person modifies an existing contract or other agreement in anticipation of T joining the group in order to shift an item between the taxable years that end and begin as a result of T joining the group if such actions are undertaken with a prohibited purpose.
In sum, the proposed regulations serve as notice from the IRS that the current application of the next-day rule to success-based fees and compensation payments triggered upon a sale is suspect in their eyes. The IRS has drawn a line in the sand that when finalized taxpayers would be wise not to cross.
Additional changes in the proposed regulations
Above and beyond the proposed changes to the next-day rule, the proposed regulations would also provide a similar rule in the S corporation context, seek to reverse the scope of the end-of-day rule and related rules where they caused unwanted results in the contexts of section 382(h) and section 1374, and make additional noteworthy changes, each discussed below.
S corporations-previous-day rule
If an S corporation joins a consolidated group, the consolidated return regulations provide a special rule that is an exception to the end-of-day rule. This special rule exists to prevent an S corporation from having to file a one-day C corporation return on the day it joins a new consolidated group. Thus, under this special rule, the S corporation target becomes a member of the consolidated group at the beginning of the termination date, and its taxable year ends for all federal income tax purposes at the end of the preceding day. This rule is often problematic because it forces the S corporation into the next-day rule, as success-based fees and the like are not fixed the day prior to the transaction. Consistent with the changes made to the next-day rule, the proposed regulations would make changes to the special rule for S corporations by way of a new previous-day rule.
The proposed regulations would retain the special rule applicable to S corporations and add a previous-day rule that mirrors the principles of the proposed next-day rule. The previous-day rule would require extraordinary items resulting from transactions that occur on the termination date (but before or simultaneously with the event causing T's status as an S corporation to terminate) to be allocated to T's tax return for the short period that ends on the day preceding the termination date.
Elimination of confusion arising from the application of the end-of-day rule under section 382(h)
In many cases, the event that causes T's change in status in the consolidated return context also causes T to undergo an ownership change for purposes of section 382. Where T is a net unrealized built-in loss corporation at the date of change, any recognition of that built-in loss (RBIL) during the five-year period (recognition period) beginning on the date of change will be treated as a deduction subject to T's section 382 limitation. In other words, the RBIL may be limited and serve to further limit T's ability to use its net operating loss carryforwards. The amount of RBILs subject to the section 382 limitation, however, is limited to the excess of the net unrealized built-in loss (NUBIL) at the ownership change date over the total RBILs during the recognition period.
As the event that causes T's status to change often causes T to undergo an ownership change, an item of deduction or loss that becomes reportable on the day of T's change in status falls within the recognition period beginning that day, even if the item is allocated to T's short period ending that day under the end-of-day rule. As a consequence, an item that should be a pre-change loss is treated as an RBIL that reduces the outstanding NUBIL balance. The Treasury does not believe this is the correct outcome, and as such, the proposed regulations seek to prevent this outcome and provide that for purposes of section 382(h), such items would not be treated as occurring during the recognition period. Rather, only items includible in T's short taxable year beginning as a result of its change in status (i.e., those items allocated to the taxable year under the proposed next-day rule), would be treated as occurring during the recognition period. Thus, the beginning of the recognition period for purposes of section 382(h) is proposed to correspond with the beginning of T's short taxable year that begins on the day after T's change in status.
Elimination of confusion arising from the application of the end-of-day rule under section 1374
As with the application of section 382(h), the event that causes T's change in status for purposes of the consolidated return rules often is the same event that causes a corporation to be subject to the section 1374 built-in-gain tax. Generally, section 1374 imposes a corporate-level tax on the gain recognized by an S corporation that was formerly a C corporation during a recognition period defined in section 1374.
Therefore, it is necessary to determine in which return (the group's consolidated return or T's separate return beginning the day after T's change in status) T's tax items for the day of T's change in status are included. The proposed regulations provide that if T ceases to be a corporation subject to the section 1374 tax upon becoming a member of a consolidated group, or if T elects to be a corporation that is subject to the section 1374 tax for its first separate return year after ceasing to be a member of a consolidated group, T's items of recognized built-in gain or loss for purposes of section 1374 will include only the amounts reported on T's separate return (including items reported on that return under the previous-day rule or the next-day rule).
Other notable changes
The items discussed above do not constitute the only changes in the proposed regulations. Following are some additional notable changes:
- Favorable change in the intercompany section 381 transaction context: The proposed regulations provide that when an intercompany section 381 transaction causes the transferor/distributor member to have a short taxable year, that short year would not be counted as a separate taxable year for purposes of determining the taxable years to which any tax attributes of that member may be carried or in which section 481(a) adjustments are taken into account.
- Favorable changes to certain filing deadlines: Where T goes out of existence during the same consolidated year in which it joined the group; the due date for filing its short period tax return that ends as a result of it becoming a member of the group would no longer be accelerated. Instead, when T goes out of existence in the same year in which it joined a consolidated group, the due date for its return would be determined without regard to T ceasing to exist.
While still in proposed format, these new regulations could have unfavorable results for many taxpayers with respect to the application of the next-day rule to success-based fee and compensation related deductions arising in M&A transactions. In light of the proposed regulations, taxpayers should consult their tax advisors when determining the treatment of these costs in future M&A transactions.
 Reg. section 1.1502-76(b)(1)(ii),
 Reg. section 1.1502-76(b)(1)(ii)
 Reg. section 1.1502-76(b)(1)(ii)(B)
 TAM 200548022.