Does A Target Or Acquiring Corporation Claim Significant Transaction-Related Deductions? IRS Wades Into Murky Waters

According to the consolidated return Regulations, when a corporation is acquired and joins a consolidated group, the acquired corporation's tax year ends at the end of the day it is acquired. 1 An exception, however, allows certain transactions that occur on the acquisition date to be allocated to the day following the acquisition. 2 Application of these distinctive provisions affect whether certain extraordinary deductions are reflected on the target corporation's separate tax return or the acquiring corporation's consolidated tax return. Limited guidance addresses how and when to apply these rules and how the consolidated return Regulations interact with other Code and regulatory provisions when extraordinary deductions are at issue.

The Internal Revenue Service (IRS) recently published a general legal advice memorandum, the "GLAM," 3 which broadly suggests that the target corporation in an acquisition must claim transaction and option cost deductions on its final separate tax return rather than allocating these amounts to the consolidated return. Although the GLAM acknowledges that other Code and regulatory provisions should be considered in this context, the memo's analysis is limited to the consolidated return provisions. As a result, the GLAM leaves the impression that this analysis is fairly straightforward; it also fails to address the government's views about how the consolidated return Regulations interact with other Code and regulatory provisions. Because taxpayers and practitioners must evaluate a range of tax issues when considering how extraordinary deductions should be parsed between parties to a transaction the IRS guidance provides limited insight into what can be a vexing challenge. Moreover, taxpayers may find that the GLAM is wielded by either IRS Exam during the course of an examination or by audit firms during provision review. Because the GLAM suggests a simplistic analysis without fully considering the range of technical issues, a taxpayer may find issues being needlessly challenged. A more thorough consideration of all of the relevant issues, however, may produce different results.

Background on the End of the Day and Next Day Rules

To appreciate the significance of the GLAM, it is important to understand the consolidated return provisions at issue in the memorandum. Whenever a subsidiary corporation either enters or exits a consolidated group, that corporation's tax year ends on the day its status changes. A consolidated return must be filed on the basis of the common parent's taxable year and it must include the common parent's items of income, gain, deduction, loss, and credit for the entire year, and each member's items for the portion of the year during which it is a member of the consolidated group. Thus, a new or departing subsidiary will have a separate federal income tax return for the portion of the year it was not a member of the consolidated group. As a result, any entering or exiting member must allocate its items of income, gain, deduction, loss and credit between the two tax periods. Although an election is available to make a pro-rata allocation of general items between the two tax periods, as described below, a separate set of rules governs the recognition of extraordinary items between the two periods.

The consolidated return Regulations provide that the change in a subsidiary company's status (entering or exiting a consolidated group) occurs at the end of the day of the status change and its tax year ends for federal income tax purposes at the end of that day (known as the "end of the day rule.") 4 The end of the day rule acknowledges that "appropriate adjustments must be made" if another Code or regulatory provision contemplates the event occurring before or after the change in status. 5 The consolidated regulations note one significant exception to the end of the day rule, the "next day rule," under which allocations are attributable to a "transaction" deemed to occur "at the beginning of the following day." 6 The Regulation is unfortunately silent on how the term "transaction" is defined.

As discussed below, the consolidated return Regulations provide that a corporation, entering or exiting a consolidated group may ratably allocate items of income, gain, deduction, loss and credit between the short periods based either on days or months. 7 Under the Regulations, however, "extraordinary items" are not eligible for the pro rata allocation, as they must be reported on the day they are recognized for federal income tax purposes. 8 Consequently, extraordinary items are subject to the application of the next day and end of the day rules, which may affect both the tax return and the tax period when extraordinary items will be recognized. 9 This rule has caused taxpayers and practitioners a great deal of concern as numerous extraordinary items arise when a member enters or exits a consolidated group. 10

Treas. Reg. Section 1.1502-76(b)(1)(ii)(B) provides that a determination as to whether a transaction is properly allocable to the portion of the subsidiary's day after the event resulting in the change will be respected if it is reasonable and consistently applied by all affected parties. In determining whether an allocation is reasonable and consistent, Treas. Reg. Section 1.1502-76(b)(1)(ii)(B) list four separate factors:

1) whether income, gain, deduction, loss, and credit are allocated inconsistently

2) if the item is from a transaction with respect to the corporation leaving or joining the consolidated group, whether it reflects ownership of the stock before or after the event 3) whether the allocation is inconsistent with other requirements under the Code and Regulations, and 4) whether "other factors" exist, such as prearranged transaction of multiple changes in the corporation's status, indicating that the transaction is not properly allocable to the portion of its day after the event resulting in the change.

These factors are subjective and the IRS's view regarding the application of each factor is not set forth. The Treasury Regulation that lists the factors includes an example from the second factor listed above regarding whether the item is from a transaction with respect to a member leaving or joining the group. The example states that, "if a member transfers encumbered land to nonmember S in exchange for additional S stock in a transaction to which Section 351 applies and the exchange results in S becoming a member of the consolidated group, the applicability of Section 357(c) to the exchange must be determined under 1.1502-80(d) by treating the exchange as occurring after the event; on the other hand, if S is a member but has a minority shareholder and becomes a nonmember as the result of a redemption of stock with appreciated property, S's gain under Section 311 is treated as from a transaction occurring before the event." 11 This example is significant in that if the corporations were filing separate returns and liabilities transferred are greater than the adjusted basis of the assets transferred in a Section 351 transaction, the transferor would recognize gain under Section 357(c). Treas. Regulation Section 1.1502-80(d), however, generally turns off the application of Section 357(c) in a consolidated return context. This example tries to resolve the conflict when a new member joins by applying Treas. Regulation Section 1.1502-80(d) immediately after the transaction, even if the corporations were unrelated prior to the transfer. The example would indicate the tax treatment of the transaction is separate from the transaction of the transfer of stock in interpreting the rule. Thus, the key for determining the application of the next day rule to a transaction appears to be separate from the transaction related to the tax issue.

Depending on the specific facts, there can be significant economic consequences if either the end of the day or the next day rule is applied. For example, if a target company is compelled to include a series of extraordinary deductions that arise as part of the transaction on its final and separate federal income tax return (for the period prior to consolidation with the buyer), the result may not clearly reflect income of the group. Further, these administrative provisions may result in the artificial recognition of items in tax years or by parties to the transaction that result in a mismatching of income and related expenses and may also fail to reflect the party that is the direct and proximate beneficiary of certain items of income and expense. More importantly, these results may be at odds with other Code and regulatory provisions.

Treatment of Transaction Costs

Analyzing the treatment of transaction costs should be no different from analyzing any other service provider fees incurred in a business context. The proper tax treatment is controlled by several factors, including: (i) whether amounts may be deducted, amortized, or capitalized; (ii) which party may take amounts into account; and (iii) when the transaction costs may be taken into account.

First, a determination has to be made as to whether the transaction costs are deductible, amortizable, or capitalizable. Transaction costs may be deducted as business expenses under Section 162(a), which provides that deductions are allowed for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, or alternatively, as an abandonment loss under Section 165, if the costs relate to an abandoned corporate transaction. 12 If the costs are incurred when an entity is creating a new trade or business, certain expenses are deductible through amortization in accordance with Section 195. In contrast, a cost that is otherwise deductible may not be deducted immediately if it is considered a "capital expenditure." Section 263(a) prohibits the "deduction of any amount paid ... for permanent improvements or betterments " and a...