Transaction Costs – Negotiating Their Tax Benefit

In any merger or acquisition, parties incur costs beyond payment of the purchase price. Transaction costs can include compensatory payments (option cancellation payments, bonuses, etc.) and professional fees (legal, accounting, and investment banking fees). Often, there are extensive negotiations over the tax benefits associated with these costs. Negotiations involving tax benefits can arise in a number of circumstances, including the following: (i) A purchaser assuming responsibility for the payment of a significant target transaction cost may be advised that the cost is not as high after the associated tax benefit is taken into account—leading to negotiations with the seller for the purchaser to claim the tax deduction. (ii) A target corporation may not have taxable income in a pre-closing period against which to offset a tax deduction—leading to an offer to allow the purchaser to claim the deduction, if it pays the selling shareholders for the tax benefit.

A basic premise of M&A tax structuring is that in evaluating an acquisition of a business, a purchaser should take into account the tax benefit resulting from the structure. For example, if a purchase of assets, or stock with an election under Code¹ Section 338(h)(10) or Code Section 336(e) yields a stepped-up tax basis, and therefore tax depreciation/amortization deductions, that should certainly be taken into account by the parties. However, negotiating which party may claim tax deductions for transaction costs and how much should effectively be “paid” for the associated tax benefits can be a bit tricky, and parties should proceed cautiously, for the reasons discussed below:

• Capitalized, amortized or deducted. For many transaction costs, there simply will be no current tax deduction. While costs may often be deducted as ordinary and necessary business expenses under Code Section 162, a cost that is a “capital expenditure” may not be currently deducted. In particular, a taxpayer must capitalize an amount paid to facilitate an acquisition of an ownership interest in a trade or business. Treas. Reg. § 1.263(a)-5. An amount is paid to facilitate an acquisition if the amount is paid in the process of investigating or otherwise pursuing the transaction—but only if it relates to activities performed on or after the “bright line date.” The bright line date is the earlier of the letter of intent date or the date of the agreement of material terms (the date of execution of a binding written agreement or date the board of directors or other authorized personnel). Even if the bright line date hurdle is cleared, if a cost is considered “inherently facilitative,” it must be capitalized. Inherently facilitative costs include costs of securing an appraisal or fairness opinion; structuring the transaction, including negotiation of the structure and obtaining tax advice on the structure; preparing the transaction documents; obtaining regulatory approval of the transaction; and obtaining shareholder approval of the transaction. Treas. Reg. § 1.263(a)-5(e)(2). Thus, to have the possibility of an immediate deduction, the cost must be incurred before the bright line date, and not fall in any of the categories of expenses deemed inherently facilitative. This limits quite significantly the universe of costs that are deductible.²

There is some good news. One important transaction cost that is generally deductible  under Section 162 is the cost of compensation triggered by the acquisition, including payments related to cancellation of nonqualified stock options and bonuses paid to target management.

• Timing of deduction. Even though compensatory payments are generally deductible, whether they may be deducted on the pre-closing tax return (generally, though not always, benefitting the seller), or the post- closing tax return (generally, though not always, benefitting the purchaser) is an issue that is governed by a multitude of tax rules. The application of some of these rules is not very clear.³ A discussion of each of these tax rules is outside the scope of this advisory, and—most  discouraging—there  is not absolute certainty as to how most of them should apply. In the absence of clear guidance (and sometimes in spite of relatively clear guidance), many parties agree contractually on the timing of the deduction, and therefore which party may claim the tax benefit on its return (or the return of target at a time when the target is owned by such party). It is important to understand that while contractual agreement on the taking and timing of a deduction may be helpful, it is not binding on the Internal Revenue Service (“IRS”). The IRS may not agree with the position the parties have taken. Unfortunately, the IRS disagreement  will likely not “turn up” until audit of one of the parties to the deal—which  likely will be years later when the opportunity for the audited taxpayer to obtain a purchase price adjustment from the other party may have passed.
• Quantification of tax benefit. Quantification of the tax benefit (and thus the amount a party pays or is paid for such benefit) is quite difficult. There are generally two approaches that may be taken in determining the value of the tax benefit. First, the parties may attempt to quantify the value of the tax benefit as of the time of the signing of the acquisition agreement, and incorporate the agreed-upon value in the purchase price. This, in our experience, does not frequently happen. Second, the parties may provide in the contract the methodology for determining the value of the tax deduction and provide for some sort of “true-up” when the tax deduction is taken. Issues that arise in determining the methodology for valuing the tax deduction include (i) whether the tax deduction will be considered to be taken as one of the first deductions the company takes, or one of the last ones (in which case it is quite possible that it won’t yield a tax benefit as the earlier deductions  will have offset all the income), (ii) when a tax benefit from the deduction will be available in the future, (iii) what discount rate should be used to determine the present value, and (iv) the value of any corresponding “lost” tax benefit to the other party.

The parties should also consider what will happen if there is an audit and the deductibility of costs that the parties have already valued, and negotiated “ownership” of, is at issue. Will the party that claimed the tax benefit be indemnified? How would the indemnification be determined? If the party claiming the tax benefit is not the party dealing with the IRS on audit, how will it protect itself and ensure that the tax benefit is in fact worth the value placed on it by the parties?

All parties to business transactions want to maximize their return. It is tempting to use tax benefits of transaction costs either to provide extra return to a party or to make the transaction costs the party is incurring a bit easier to accept. However, parties should tread carefully in this area. While ultimately dependent on the underlying facts, there may be uncertainty as to the existence of the tax benefit. Further, any “trading” of the tax deduction and an agreement that it be allocated to a certain party—and therefore claimed by it—may be inconsistent with the governing tax rules.

The above discussion addresses the relevant tax issues and structuring at a high level only. Please consult members of the Ballard Spahr Tax Group for further discussion.

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¹ References to Code Sections are to Sections of the Internal Revenue Code of 1986, as amended.

² That said, the IRS did in 2011 issue a Revenue Procedure permitting taxpayer a deduction of 70 percent of success-based fees for most transactions. Rev. Proc. 2011-29. These are costs contingent upon the closing of transactions—a common fee structure for investment banking services.

³ Generally, these rules include Section 83(h) of the Code, the consolidated return regulations (where the target corporation is entering or leaving a consolidated group), the method of accounting of the payor, and the time for economic performance under Sections 404(a)(5) and 461(h) of the Code.