Mergers and acquisitions typically involve significant transaction costs. These transaction costs may produce ordinary income tax deductions for the year of the transaction, over a period of time or not at all—depending on the nature of both the transaction and the costs.
The taxpayer in a recently-released Technical Advice Memorandum (TAM) argued that its transaction costs should avoid the third category, and tax deductions should be allowed for all of the costs. The IRS disagreed in TAM 202004010. Recognizing that its regulations did not provide all of the answers, the IRS looked to federal income tax case law for guidance.
Acquisition and disposition of Target
The taxpayer in the TAM (Buyer) was a corporation that had purchased the stock of another corporation (Target). Buyer and Target both incurred significant costs in connection with the transaction.
The transaction costs included payments to law firms, investment banking firms, accounting firms, other professional firms, and the Securities and Exchange Commission. To determine the currently deductible portions of these costs, Buyer and Target applied tax rules set out in Treasury Regulations and Revenue Procedure 2011-29. Buyer and Target capitalized the costs not currently deductible.
Buy-side capitalized costs
Buyer did not treat its capitalized costs as costs incurred to purchase stock; doing so would increase Buyer’s tax basis in its Target stock, but would never result in an ordinary tax deduction because the Target stock was a capital asset in the hands of Buyer. Instead, Buyer capitalized these costs for tax purposes as if they created an intangible asset held by Buyer separate from the Target stock.
Subsequently, Buyer sold its Target stock to New Buyer. Buyer reported the previously capitalized Target acquisition costs as an ordinary deduction for the year of the sale to New Buyer.
The IRS noted that the intangible asset reported by Buyer on its tax returns did not correspond to any property interest or rights of measurable value in money's worth that is subject to protection under applicable law and capable of being sold, transferred or pledged. As such, Buyer’s asserted asset did not represent a separately identifiable intangible asset under applicable tax regulations.
The IRS concluded that the transaction costs Buyer capitalized in this stock acquisition transaction should be capitalized as an addition to Buyer’s tax basis in its Target stock, and did not give rise to any ordinary deductions. Although tax regulations do not expressly require this result, the IRS found that adding Buyer’s costs to its Target stock basis was required under case law, including the Supreme Court’s decision in INDOPCO, Inc. v. Comm’r, 503 U.S. 79 (1992).
Sell-side capitalized costs
Similarly to Buyer, Target treated its capitalized transaction costs for tax purposes as if they created an intangible asset held by Target. Target deducted the previously capitalized Target acquisition costs as worthless on its consolidated federal income tax return with Buyer for the year of the sale to New Buyer.
The IRS denied this deduction for Target’s capitalized transaction costs. Like Buyer’s capitalized costs, Seller’s capitalized costs did not create a separately identifiable intangible asset under the applicable tax regulations because the costs did not correspond to any property interest of measurable value subject to protection under applicable law and intrinsically capable of being sold. Those regulations, however, do not expressly set out how Target’s capitalized costs should be treated.
Interestingly, the IRS did not argue that these costs were nondeductible under section 1032 because they related to a sale of Target’s stock. The IRS apparently did not view that argument as viable because Target did not sell or acquire any of its own stock in the transaction.
Instead, the IRS viewed Target’s capitalized transaction costs as incurred for the purpose of enhancing Target’s operations. The IRS stated, citing INDOPCO, that no recovery of these costs would be permitted until the dissolution of Target or some other event that ends the useful life of the business. Since the facts did not demonstrate that Target abandoned its business or that Target’s business operations were dissolved, no deduction would be available. The IRS also noted that there was no evidence that Target’s business had become worthless. Target’s capitalized transaction costs, the IRS concluded, did not give rise to a loss deduction upon Buyer’s sale of Target to New Buyer as taxpayer had claimed.
Addressing costs capitalized in a stock acquisition, the IRS clearly stated that Buyer’s costs should be added to the tax basis in the acquired stock. This result is quite sensible and straightforward.
The IRS did not provide such a straightforward characterization of any particular asset receiving tax basis as a result of Target’s capitalized costs. Rather, the TAM concludes that Target’s capitalized costs may not be recovered as a loss until Target’s business is discontinued or becomes worthless.
Taxpayers should consult with their tax advisors and analyze their transaction costs under applicable Treasury Regulations and case law to determine their deductibility. For a broader and more in-depth discussion of transaction cost analysis, please refer to prior RSM article.