The Internal Revenue Service (the Service) recently released Priv. Ltr. Rul. 2013-19-009,1 which interprets the transaction cost regulations of Treas. Reg. §1.263(a)-5. Under these rules, transaction costs associated with certain "covered" transactions receive favorable tax treatment.2 Covered transactions include various reorganizations and taxable acquisitions; the rules generally exclude non-taxable, divisive and other corporate transactions. The ruling is significant because the Service found that a hybrid transaction, which involved both a taxable acquisition and a non-taxable exchange (here, a Section 351 transaction), qualified as a covered transaction. While this position could be inferred from previous rulings, this ruling makes the government’s view explicit. Although the ruling provides welcomed insight, it unfortunately does not provide broad guidance regarding the application of the covered transaction rules, which means questions remain for both tax return and provision purposes. It is unclear from the ruling whether all hybrid transactions, or merely certain ones, qualify for covered transaction status.
Background – PLR 2013-19-009
Under Treas. Reg. §1.263(a)-5(a), a taxpayer must capitalize an amount paid to facilitate any one of ten specified transactions. The list of specific transactions includes for example: certain acquisitive transactions;3 debt issuance;4 stock issuance;5 writing an option;6 and a tax-free exchange under Section 351 or 721.7 These regulations provide that capitalization is required for costs that facilitate one of these transactions, and specify that the costs of investigating a transaction are generally considered facilitative. That is, transaction costs that are attributable to services provided in the process of investigating or pursuing one of the ten transaction types are generally considered non-deductible.
However, the regulations provide a significant exception for costs associated with investigating a transaction defined as a covered transaction. Specifically, costs incurred prior to a definitive decision to proceed with a transaction may be deducted (generally referred to as the bright-line date rule.)8 For this purpose, the regulations describe covered transactions as: (i) taxable acquisitions of assets that constitute a trade or business; (ii) taxable acquisitions of an ownership interest in a business entity if immediately after the acquisition the parties are related; and (iii) certain reorganizations.9
In Priv. Ltr. Rul. 2013-19-009, the transaction at issue was an acquisition of Company 2, by Parent and Company 1. To effect the acquisition, Parent was formed by Company 1, followed by Parent forming two merger subsidiaries. One of the merger subsidiaries merged into Company 1 through a one-for-one Parent stock exchange. The remaining subsidiary merged into Company 2 for an exchange consisting partially of cash and Parent stock. The initial acquisition, involving an all-stock exchange, was not at issue. The focus of the letter ruling was the second acquisition that resulted from a partial cash and stock exchange. This transaction was considered to be both a taxable acquisition leading to gain recognition, and a non-taxable and qualified exchange under Section 351.
The issue in this letter ruling was whether the partial cash and stock exchange constituted a covered transaction within one of the classifications provided in the regulations. The Service takes the position that an acquisition qualifies as a covered transaction even though the Section 351 transaction on its own would not be considered a covered transaction. Therefore, costs must be analyzed in light of the bright-line date rule to determine whether they will be capitalized. This position is significant because notwithstanding the hybrid nature of the transaction, the Service deemed the transaction to be considered a taxable acquisition and thus, qualified as a covered transaction.
It is important to note that Treas. Reg. §1.263(a)-5(a)(5) provides that transfers described in Section 351 and 721 are subject to the general rules of the regulations. Thus, investigatory costs associated with such transactions are generally presumed non-deductible. Of course, if the Service had found all of the Company’s transaction costs non-deductible, the result would have minimized the taxable aspects of the overall nature of the transaction, which qualifies for the bright-line date rule and hence favorable tax treatment. This approach is often argued by IRS Exam; however, it is inconsistent with the approach that has been enunciated by the IRS National Office. Further, the Service could have chosen to apportion the transaction costs according to the respective value of each portion of the transaction. The overall transaction could have been viewed as a bifurcated transaction, with transaction costs apportioned to the taxable piece and the non-taxable piece. Following such an approach, the bright-line date rule would be applied to the portion of the transaction costs applied to the covered transaction. It is likely that this approach wasn’t followed because the Service focused on the fact that controlling case law provides that the characterization of an amount as either deductible or non-deductible is based on the scope of services rendered and not the tax treatment of the transaction.10 Further, service providers, such as investment bankers, are focused on investigating an overall transaction and they are necessarily not focused on the taxable or non-taxable aspects of a particular transaction. As such, it would be extremely difficult, if not impossible, for an advisor to parse services in this manner, and thus make determining the federal tax treatment of costs difficult.
While the conclusion in this private letter ruling is specific only to the facts of this transaction, it does provide some insight into the Service views regarding transaction costs and covered transactions. This ruling is consistent with earlier letter rulings in which the Service suggested that hybrid transactions could be considered covered transactions.11 It is also consistent with results previously set forth in Pre-Filing Agreements and agreements reached both at Exam and at Appeals. What is left unanswered is the standard to be applied in other situations. It is unclear precisely when a transaction will be considered covered and whether there are situations in which the non-taxable nature of a transaction may fail to qualify as a covered transaction. It would seem that a reasonable conclusion is that a transaction may be considered covered as long as the non-taxable portion of the transaction is not greater than the taxable portion of the transaction. This private letter ruling demonstrates that the covered transaction rules are drawn narrowly and consideration should be given to application of the covered transaction rules whenever a hybrid transaction occurs.
1 (May 10, 2013).
2 Treas. Reg. §1.263(a)-5(e)(3) defines covered transaction and Treas. Reg. §1.263(a)-5(e)(1) describes exception available for investigatory costs incurred in a covered transaction.
3 Treas. Reg. §§1.263(a)-5(a)(1), (2) and (3).
4 Treas. Reg. §1.263(a)-5(a)(9).
5 Treas. Reg. §1.263(a)-5(a)(8).
6 Treas. Reg. §1.263(a)-5(a)(10).
7 Treas. Reg. §1.263(a)-5(a)(5).
8 For covered transactions, an amount is not facilitative and thus, otherwise deductible, if it relates to activities performed before the earlier of 1) the date on which a letter of intent or similar agreement is executed between acquirer and target, or 2) the date on which the material terms of the transaction are approved by the board of directors. Significant to this guidance is whether a transaction is deemed to be covered based on the regulations for this section, thus giving rise to the facilitating analysis.
9 Treas. Reg. §1.263(a)-5(e)(3).
10 See, e.g., Staley Mfg Co. v. Comm’r, 119 F.3d 482 (7th Cir. 1997), at 489-90, (explaining that the nature of the services performed determines the proper tax treatment of the costs attributable to those services) (citing Honodel v. Comm’r, 76 T.C. 351, 365 (1981), aff’d, 772 F.2d 1462 (9th Cir. 1984)).
11 See Priv. Ltr. Rul. 2008-30-009 (Sept. 25, 20078) and 2009-53-014 (Dec. 31, 2009) (finding investigatory costs incurred prior to the bright-line date to be deductible, reinforcing that transactions involving tax-free aspects qualified as covered transactions).