On March 13, 2018, the Large Business and International (LB&I) Division of the Internal Revenue Service (IRS) announced five new compliance campaigns. The five campaigns supplement the 13 initial campaigns released in January 2017 as well as the 11 campaigns announced in November 2017. The LB&I campaigns are supported by strategic planning, training and tools, metrics, and feedback. The new campaigns continue the IRS’s move to issues-based examinations that focus on risks identified in the field and which enable LB&I to target resources to specific issues for examination. One of the announced campaigns involves the review of whether taxpayers properly capitalized, rather than deducted, transaction costs associated with certain tax-free distributions under section 355.
Transaction Cost Background
The treatment of corporate transaction costs has long been a focus of IRS Exam. Since the US Supreme Court’s decision in INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992) (finding that the target corporation in a friendly acquisition must capitalize certain investment banking and legal fees incurred in the transaction), taxpayers and the IRS have been at odds regarding the scope of costs that are deductible when a corporate transaction is completed.
The Treasury Department put certain issues to rest in 2004 with the release of regulations addressing the distinctions between costs required to be capitalized and those that could be deducted immediately. The “Transaction Cost Regulations,” contained in Treas. Reg. § 1.263(a)-5, generally require capitalization of costs of facilitating 10 types of transactions, including “a restructuring, recapitalization, or reorganization of the capital structure of a business entity (including reorganizations described in section 368 and distributions of stock by the taxpayer as described in section 355).” Treas. Reg. § 1.263(a)-5(a)(4).
Activities that are considered facilitative include activities required to close a corporate transaction, such as securing an appraisal; structuring the transaction; preparing or reviewing documents to effectuate the transaction; and preparing or reviewing regulatory filings. See Treas. Reg. § 1.263(a)-5(e)(2). Although the Transaction Cost Regulations provide that facilitative costs are non-deductible, these rules also permit the deduction of otherwise deductible amounts. A significant category of deductible costs is investigatory due diligence attributable to a “covered transaction” as long as these services are provided prior to the time a company makes a final decision to proceed with the completed transaction. See Treas. Reg. § 1.263(a)-5(e)(1). For this purpose, a “covered transaction” generally includes taxable asset and stock acquisitions and non-divisive tax-free reorganizations. See Treas. Reg. § 1.263(a)-5(e)(3).
Campaign Addressing Section 355 Transaction Costs
Consequently, whenever a company completes a tax-free distribution under section 355, there is a question about the scope of deductible and non-deductible costs. In these spin-offs, split-offs, and split-ups, companies invariably incur significant transaction costs, including costs that are incurred specifically to facilitate the transaction. The new campaign is focused on whether taxpayers properly capitalized, rather than deducted, facilitative costs attributable to section 355 transactions.
In light of the frequent number of section 355 transactions, LB&I may have identified the new compliance campaign in response to a rise in such transactions. Alternatively, the compliance campaign may be directed to transactions that encompass both a section 355 transaction as well as a covered transaction. Companies undergoing a transaction that includes both a section 355 transaction and an acquisition/reorganization that qualifies as a covered transaction under Treas. Reg. § 1.263(a)-5(e)(3) must parse transaction costs between the transactions and then determine the portion of deductible and facilitative costs allocable to each transaction. More importantly, the two distinctive transactions may be viewed by some as a single covered transaction with the result that relatively more of the costs attributable to the section 355 transaction are treated as deductible than if each transaction were evaluated separately. The addition of this new campaign may have been designed by LB&I to focus the attention of its agents on such transactions to ensure that companies have not deducted more than the amounts allowed under the Transaction Cost Regulations.
Eversheds Sutherland Insight
Since the INDOPCO decision, the IRS has routinely examined corporate transaction costs in an examination context. As the government gained confidence regarding the appropriate amount of deductible transaction costs associated with acquisitive transactions, the IRS issued Rev. Proc. 2011-29, 2011-18 I.R.B. 746, which provides a safe harbor election under which a taxpayer may currently deduct 70% of success-based fees paid in business acquisitions or reorganizations if the remaining 30% is capitalized as inherently facilitative. Taxpayers electing the safe harbor treatment are not required to maintain documentation supporting the treatment of success-based fees. The safe harbor election has simplified the treatment of success-based transaction costs. It is possible that this campaign could result in a similar safe harbor for section 355 transactions.