On January 28, 2013, the Internal Revenue Service (IRS) published a generic legal advice memorandum (GLAM), AM2012-10, addressing the timing under the consolidated return regulations of certain deductions that commonly arise in an acquisition, including compensation deductions attributable to amounts paid to cash out a target company's non-qualified stock options (NQOs) and stock appreciation rights (SARs) held by employees. The factual scenario addressed in the GLAM is typical of many acquisitions—a taxable reverse triangular merger in which a target corporation is acquired by a corporation that is a member of a consolidated group. The only consideration in the acquisition in the GLAM was cash, but the IRS's reasoning and result would apply equally in a tax-free reorganization in which some or all of the consideration is stock.
The acquisition in the GLAM resulted in the target company becoming a member of the acquiring group, thus resulting in a short taxable year for the target, ending on the acquisition date. The GLAM analyzed three separate items:
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Item 1: The target had outstanding NQOs and SARs held by certain of its employees. As a result of the acquisition, the target became obligated to cash out the NQOs and SARs for an amount that was "fixed and determinable" at the closing of the acquisition.
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Item 2: The target had engaged financial advisory and investment banking firms in connection with the acquisition. The firms' fees were contingent upon the successful closing of the acquisition, and became fixed and determinable upon closing.
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Item 3: The target company had certain bonds outstanding. As part of the negotiations, the target agreed to give its bondholders the opportunity to tender their bonds at a premium. (Bond premiums may be deductible when paid.) Bonds were tendered prior to the closing of the acquisition, but no bonds were redeemed until after the closing, following the target's acceptance of the tendered bonds.
At issue in the GLAM was the timing of the current deductions resulting from these three items. The economic consequences of this timing can be significant, since if the deductions are properly allocable to the pre-closing period, they may merely increase the target company's net operating loss, the utilization of which will be subject to an annual limitation under IRC Section 382 as a result of the acquisition. Depending on the extent of the limitation, deductions in the pre-closing period are often not nearly so valuable to a profitable acquiring group as deductions allocable to the post-closing period.
Under the default rule of Treasury Regulation Section 1.1.502-76(b)(2)(ii), accrued deductions generally are allocable to the target's short taxable year ending on the closing date (i.e., pre-closing period). However, the "next-day" rule of Treasury Regulation Section 1.1502-76(b)(1)(ii)(B) provides for an exception to the normal rule if the transaction giving rise to the deduction is "properly allocable to the portion of Target's day after the event resulting in the change." If a deduction is allocable to the portion of the target's day after it has become a member of the acquiring group, the target's deduction usually would be available to the acquiring group without being subject to the limitations of Section 382.
With respect to the first two items, the IRS concluded that payments to employees and financial advisors that are otherwise deductible are not properly allocable to the portion of the day of closing after the closing occurred (and thus cannot be allocated to the post-closing period). After a brief discussion, the IRS concluded that allocating these deductions to the post-closing period would be "neither proper nor reasonable," because the obligation to make these payments became fixed and determinable at closing and arose from "transactions" that preceded the acquisition (i.e., the performance of services for the target prior to the closing).
With respect to the third item—deductions arising from the retirement of the target company's outstanding bonds—the IRS indicated that it would be reasonable to report any deductible amount in the post-closing period. The target's legal obligation to redeem the bonds was not fixed until it accepted the tendered bonds for redemption, which occurred after the closing. Unlike the first two items, where the closing of the acquisition established the amount of (and legal obligation to make) the payment for pre-closing services, the closing of the acquisition did not obligate the target to redeem any of the bonds.
The GLAM is not binding legal authority, but is a significant statement of the IRS's position with respect to what can be a material issue in an acquisition. If the IRS is correct, option deductions and certain other deal-related deductions that cannot be allocated to the post-closing periods will be immediately useable only if the target is profitable, or possibly if it had been profitable in prior periods and can claim a refund. The GLAM thus not only is potentially problematic for acquirers but also for sellers trying to monetize the value of these deductions.
The GLAM highlights the importance for both acquiring and target companies of identifying the key elements of possible tax value in a transition, analyzing the applicable tax treatment, and then negotiating the allocation of the economic benefit of those items in the early stages of a transaction. (A closely related, but often overlooked, issue in the context of option cash-outs or other compensatory payments involves the allocation between buyer and seller of the economic impact of the employer payroll taxes incurred by a target entity in connection with an acquisition, which in many cases are non-trivial.) Once the basic economic terms have been negotiated, it can be difficult to reopen those issues to address previously unidentified tax benefits.
To learn more about this topic, please contact Gregory Broome, Michael Faber, Ivan Humphreys, Eileen Marshall, Jonathan Zhu, or another member of the firm's tax practice.
IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under federal, state, or local tax law or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.
