[author: Clayton Garrett]
When the IRS released the transaction cost regulations of Treas. Reg. 1.263(a)-5, a new term was created: “covered transaction.”1 Unlike the treatment of a covered transaction in a tax shelter context, which is generally unfavorable, the transaction cost regulations accord more favorable tax treatment for a corporate transaction that is considered a covered transaction. Under these rules, costs incurred investigating a covered transaction may be deducted.2 Further, a safe harbor revenue procedure provides simplifying measures for determining corporate transaction cost deductions, provided the transaction is considered a covered transaction.3
Unfortunately, however, the transaction cost regulations created the term for administrative convenience and it was not developed through case law. As a result, there is limited authority explaining the scope of the term.4 Taxpayers seeking to determine when a transaction is considered a covered transaction frequently face questions due to limited authority. The lack of authority may affect companies preparing tax returns or completing tax provision review as part of their audit process. More importantly, transactions that fall outside of the scope of the narrow language of the transaction cost regulations are more likely to be challenged when a taxpayer is subject to IRS Examination.
A recent private letter ruling addresses whether a particular transaction may be considered a covered transaction. This private letter ruling follows other previously issued letter rulings that also considered whether various corporate transactions were covered transactions. Even though private letter rulings are informal guidance and reliance is limited to the taxpayer receiving the ruling, these rulings offer IRS background and analysis on the issue.5 The analysis may be considered when evaluating whether subsequent transactions are covered transactions. Further, the IRS recently updated its directive to field agents examining transaction costs, providing a more expansive approach to use of the safe harbor by taxpayers completing covered transactions. Although the regulations and ruling guidance fail to definitively address covered transactions, additional insight into IRS views on the issue is provided. As increasing rulings confirm that varied transactions are properly treated as covered, it may be possible to infer that the term should be interpreted broadly.
Under the transaction cost regulations, a covered transaction is broadly defined to include taxable asset or stock acquisitions and non-divisive tax-free reorganizations. Specifically, Treas. Reg. §1.263(a)-5(e)(3) defines a covered transaction as: (i) a taxable acquisition of assets constituting a trade or business; (ii) a taxable acquisition of an ownership interest in a business entity (whether acquirer or target) as long as the parties are related following the transaction; and (iii) 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 are transferred or distributed in a transaction that qualifies under Sections 354 or 356 (whether the taxpayer is acquirer or target).
When a transaction is designated as a covered transaction, a taxpayer is not required to capitalize the costs of investigating a corporate transaction.6 As a practical matter, this means that companies may deduct costs associated with investigatory due diligence resulting in significant deductions if a transaction was costly to complete. Additionally, the IRS has issued an administrative safe harbor providing a simplified determination of deductible transaction costs. However, the safe harbor is limited to covered transactions.7
Because of the benefits of characterizing a transaction as a covered transaction, questions frequently arise regarding how to treat a particular transaction, for example, a transaction with multiple steps or involving both taxable and non-taxable components. Previous IRS items offer insight into how the term should be applied; a newly released private letter ruling and updated Exam Directive provide additional insight into this determination.
Private Letter Ruling 2014-05-009 – IRS Concludes That a Call Option May Be Viewed Together With a Taxable Acquisition and Considered a Covered Transaction
The facts of the private letter ruling involved a corporate taxpayer, which was the common parent of an affiliated group of corporations filing a consolidated federal income tax return. The corporate taxpayer indirectly owned all of the issued and outstanding common stock of Sub1, a foreign corporation, which in turn owns Sub2, which is a disregarded foreign entity. In a taxable acquisition, the corporate taxpayer acquired a partial ownership interest in the target partnership and also secured an option to acquire the remaining ownership, which was characterized as a “Call Option.” The Call Option was exercisable in whole, but not in part, during a limited future period after the closing of the transaction.8
Prior to the acquisition, the target was a disregarded entity that owned an interest in a partnership, with a trust owning the balance thereof. This partnership owned (directly and directly through disregarded entities) all of the common stock of a number of foreign corporations.
To effect the deemed acquisition by Sub1 of the partial ownership interest in the target, the taxpayer contributed cash and taxpayer common stock through the ownership chain to Sub2, which paid the seller for the purchase of the partial ownership interest.
Pursuant to the terms of the agreement and immediately prior to the abovementioned acquisition, the seller caused the trust to exchange its ownership interest in the partnership for a new ownership interest in the target. The ownership interest in the target acquired by the trust was then part of the ownership interest purchased by the taxpayer in the first part of the acquisition. Similarly, upon exercising the Call Option, the seller will cause the trust to exchange its remaining interest in the partnership for a new ownership in the target. The ownership interest in the target will then be part of the ownership interest acquired by the taxpayer via the Call Option.9
At issue in the private letter ruling was whether the option to acquire the remaining ownership of the partnership could be considered an option to buy the partnership’s foreign subsidiaries for purposes of the covered transaction rules.
The IRS ruled that a call option should be viewed as an option to acquire a percentage interest in the stock of each of the targets. Further, because of the Call Option, the IRS concluded that the corporate taxpayer and each of the foreign targets were related, within the meaning of Section 267(b)(3), immediately after the closing of the Step One Acquisition. The transaction cost regulations provide that a taxable acquisition of an ownership interest is a covered transaction if, “immediately after the acquisition, the acquirer and the target are related within the meaning of Section 267(b) or Section 707(b).”10 As a result of this determination, the IRS concluded the Acquisition to be a covered transaction within the meaning of Treas. Reg. §1.263(a)- 5(e)(3)(ii) with respect to each of the foreign corporations.
In 2013, the IRS also released a private letter ruling regarding a covered transaction.11 The transaction at issue involved an acquisition of Company 2, by Parent and Company 1. To effect this acquisition, Company 1 formed Parent, which then formed two merger subsidiaries. One of the merger subsidiaries therein merged with and into Company 1 through a one-for-one Parent stock exchange. The additional merger subsidiary merged with Company 2 through an exchange consisting partially of cash and Parent stock. As a result of the exchange consisting of cash and stock, the merger with Company 2 was considered a taxable acquisition leading to gain recognition, as well as a nontaxable and qualified exchange under Section 351. Consequently, the focus of the ruling centered on whether the partial cash and stock exchange constituted a covered transaction within the meaning of the transaction cost regulations. In this ruling, the IRS determined that the transaction qualified as a covered transaction, despite the fact that the Section 351 portion of the acquisition would not have qualified on its own.
The 2013 private letter ruling maintains consistency with earlier rulings on covered transactions involving a hybrid acquisition. In Private Letter Ruling 2008-30-009 (July 25, 2008), several favorable rulings were secured in a going-private transaction funded by a private equity and company management. The target company was acquired through the merger of an acquisition company with and into the target company, with the target surviving. The exchanging shareholders received cash in the transaction. Prior to the transaction, a group of private equity funds created Parent, Intermediate Hold Co., and Acquisition Co. To effect the merger, company management initially contributed stock in a Section 351 transaction in exchange for Parent stock. As a result, the private equity funds and company management owned Parent. Acquisition Co. was a subsidiary of Intermediate Hold Co., which was a subsidiary of Parent. Acquisition Co. merged with and into the target, which then became a wholly owned subsidiary of Intermediate Hold Co. In providing several other favorable rulings,12 the IRS reached the conclusion that the multi-step going-private transaction qualified as a covered transaction within the meaning of the transaction cost regulations. This ruling is significant because of the overall hybrid nature of the transaction and the steps undertaken to effect the merger, which standing alone may not have qualified for such treatment.
Each of these private letter rulings concluded that the corporate transactions were covered transactions. The private letter rulings were sought so that the taxpayers could secure certainty regarding treatment, either for tax return purposes, provision review purposes, or to gain finality regarding the characterization of the transaction. If it is ambiguous whether a corporate transaction is designated as a covered transaction, in a public company context, a reserve may be required to reflect the ambiguity. Because the description of a covered transaction is limited in the regulations, it may be important to seek clarification with a letter ruling when there is an outstanding question. When there is an ambiguity, a favorable private letter ruling eliminates uncertainty. Even though these rulings all conclude that the transactions could be viewed as covered transactions, it is important to be aware that the IRS regularly challenges whether a transaction is a covered transaction in an Exam context to disallow investigatory deductions. A favorable letter ruling will also minimize IRS Exam challenge and also likely eliminate the requirement to set up a tax reserve for this issue.
LB&I-04-0114-001 (Jan. 27, 2014) – IRS Updates its Directive Regarding Milestone Payments
Through a recently issued Large Business & International directive (“Directive #3”), the IRS has updated a prior LB&I directive (the “Directive #2”)13 to provide LB&I examiners with a new definition of “milestone” to consider when analyzing a taxpayer’s treatment of “eligible milestone payments” made or incurred in the course of a covered transaction14 for which the taxpayer incurs a success-based fee.
As briefly discussed above, the IRS issued Revenue Procedure 2011-2915 to provide a safe-harbor election for allocating success-based fees paid or incurred in covered transactions. Instead of maintaining the documentation required by Treas. Reg. § 1.263(a)-5(f) to support a deduction for a portion of a success-based fee, Revenue Procedure 2011-29 allows an electing taxpayer to treat 70 percent of a success-based fee as an amount that does not facilitate the covered transaction. The remaining 30 percent of the fee is capitalized as an amount that facilitates the covered transaction. Revenue Procedure 2011-29 applies only to success-based fees paid or incurred in tax years ended on or after April 8, 2011.
In an LB&I directive issued in July 2011 (“Directive #1),16 the IRS directed LB&I examiners not to challenge a taxpayer’s treatment of success-based fees paid or incurred in a covered transaction in tax years ended before April 8, 2011, as long as the taxpayer’s original return position was to capitalize the successbased fees related to the covered transaction in an amount of at least 30 percent of the total fees incurred by the taxpayer for the covered transaction.17
In CCA 201234027 (Aug. 27, 2012), however, the IRS determined that milestone payments payable upon the signing of a merger agreement and upon shareholder approval of the transaction were not eligible for the safe harbor. Under the facts of the CCA, the milestone payments were nonrefundable if the transaction did not close. Once the milestone payments were paid, however, they were creditable against the successbased fee owed upon the close of the transaction. The IRS reasoned that a success-based fee is an amount paid or incurred that is contingent on the successful closing of a transaction described in Treas. Reg. § 1.263(a)-5(a). The CCA reasoned that nonrefundable milestone payments are not contingent on the successful closing of the transaction; rather guaranteed payments incurred upon the occurrence of a specified milestone or upon some other date or event. For this reason, the CCA concluded that these payments are not success-based fees and, as such, do not qualify for the safe harbor.
Notwithstanding the conclusions in the CCA, the IRS issued Directive #2,18 advising LB&I examiners not to challenge a taxpayer’s treatment of eligible milestone payments made or incurred in the course of a covered transaction described in Treas. Reg. § 1.263(a)-5(e)(3) for which the taxpayer incurs a success-based fee if the taxpayer: (1) elected the safe harbor; (2) did not deduct more than 70 percent of the eligible milestone payments incurred in connection with the success-based fees; and (3) is not contesting its liabilities for the eligible milestone payments.
Directive #2 defined “eligible milestone payment” as a milestone payment paid for investment banking services that is creditable against a success-based fee. It limited the term “milestone,” however, to an event occurring in the course of a covered transaction (whether completed or not), provided that the event is: (i) the execution of a letter of intent or exclusivity agreement; (ii) board approval; or (iii) an event occurring after (i) and (ii).
Directive #3 defines “milestone” as “an event, including the passage of time, occurring in the course of a covered transaction (whether the transaction is ultimately completed or not).” As such, the term no longer excludes events occurring before board approval or the execution of letters of intent or exclusivity agreements. The new directive does not, however, change the definition of “eligible milestone payment.” Again reiterating that an eligible milestone payment is one paid for investment banking services credited again a success-based fee.
Broadening the definition of milestone will assist in eliminating ambiguity regarding the treatment of fees encompassing such payments. However, with guidance only applicable to investment banking fees, ambiguity continues with respect to other types of fees.
The regulations and other IRS items do not fully address when a transaction is considered a covered transaction. As a result, companies continue to struggle with evaluating whether various corporate transactions qualify for favorable treatment available to covered transactions. More importantly, transactions failing to fall squarely within the limited regulatory language will continue to be subject to challenge at IRS Exam.
Nonetheless, insight may be gleaned from IRS publications regarding when certain transactions are considered covered transactions. This insight is helpful when evaluating unique, hybrid, or multi-step transactions. Because this determination affects the tax treatment of various corporate transaction costs and reserve requirements, it is important to carefully consider how such transactions should be evaluated in light of the covered transaction rules.
1 See generally, Treas. Reg. §1.263(a)-5(e)(3).
2 Treas. Reg. 1.263(a)-5(e)(1).
3 Rev. Proc. 2011-29, 2011-18 I.R.B. (April 8, 2011).
4 See Priv. Ltr. Rul. 2013-19-009 (May 10, 2013) (finding the acquisition of a company through the use of two merger subsidiaries to be a covered transaction, despite the fact that the transaction included both a taxable acquisition leading to gain recognition, as well as a non-taxable qualified exchange under Section 351); Priv. Ltr. Rul. finding investigatory costs incurred prior to the bright-line date to be deductible, reinforcing that transactions involving taxfree aspects qualified as covered transactions. See also, Priv. Ltr. Rul. 2008-30-009 (July 25, 2008) (finding investigatory costs incurred prior to the bright-line date to be deductible, reinforcing that transactions involving tax-free aspects qualified as covered transactions). Also note, private letter rulings are based upon information and representations submitted by the taxpayer, and are directed only to the taxpayers requesting it. Further, these rulings may not be used or cited as precedent.
5 I.R.C. § 6110(k)(3).
6 Treas. Reg. §1.263(a)-5(b) provides that an amount paid by the taxpayer in the process of investigating or otherwise pursuing a transaction facilitates the transaction, which means that a taxpayer must capitalize the costs associated with investigating and completing a corporate transaction. However, the regulations provide a significant exception for covered transactions. Treas. Reg. §1.263(a)-5(e) provides that the costs of investigating a covered transaction are deductible as long as the costs are incurred prior to the so-called bright-line date and these amounts are not for inherently facilitative services.
7 Rev. Proc. 2011-29, 2011-18 I.R.B. (April 8, 2011) (allowing taxpayers incurring success-based fees paid to facilitate a covered transactions to treat 70 percent of the costs as not facilitative).
8 Together, the partial acquisition and the right to purchase the remaining portion thereof, were referenced as the “Step One Acquisition.”
9 This portion of the transaction was referenced as the “Step Two Acquisition.”
10 Treas. Reg. Sec. 1.263(a)-5(e)(3)(ii). See also, Section 267(b)(3) whereby two corporations are related if they are members of the same controlled group as defined in Section 267(f). Section 267(f) defines “controlled group” in reference to Section 1563, substituting “more than 50 percent” for “at least 80 percent.” Further, note that under Section 1563(e), an option to acquire stock is considered an ownership interest therein.
11 Priv. Ltr. Rul. 2013-19-009 (May 10, 2013).
12 See generally, Priv. Ltr. Rul. 2008-30-009 (July 25, 2008), whereby the taxpayer also secured favorable rulings on a number of issues, including taking deductions for expenses incurred by entities other than the target company, permitting allocation of costs based on the entity to which the services were rendered and/or on whose behalf the services were provided, permitting the amortization of financing costs, and permitting an abandonment loss in regard to a failed financing effort.
13 LB&I-04-0413-002 (April 29, 2013).
14 See Treas. Reg. §1.263(a)-5(e)(3), which defines a covered transaction as: (i) A taxable acquisition by the taxpayer of assets that constitute a trade or business; (ii) A taxable acquisition of an ownership interest in a business entity (whether the taxpayer is the acquirer in the acquisition or the target of the acquisition) if, immediately after the acquisition, the acquirer and the target are related within the meaning of section 267(b) or 707(b); (iii) 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 which qualifies under section 354 or 356 (whether the taxpayer is the acquirer or the target in the reorganization).
15 2011-18 I.R.B. 746.
16 LB&I-04-0511-012 (July 28, 2011).
17 Id. 18.
18 LB&I-04-0413-002 (April 29, 2013).