New Directive Correctly Resolves Use Of Transaction Cost Safe Harbor For Milestone Payments – Questions Nonetheless Linger

A new directive specifies that Large Business & International (LB&I) examiners should not challenge a taxpayer's treatment of eligible milestone payments when success-based fees1 are incurred, provided a safe harbor election pursuant to Rev. Proc. 2011-292 has been made.3 This directive provides welcome relief and suggests a reversal of the Internal Revenue Service's previous position regarding milestone payments.

Under the Rev. Proc. 2011-29, a taxpayer may elect to treat 70 percent of all success-based fees as nonfacilitative, and treat the remaining 30 percent of the success-based fee as capitalizable. With the election, taxpayers may forgo the challenging task of maintaining the documentation required in Treas. Reg. 1.263(a)-5(f) to support the allocation of these transaction costs. Although the revenue procedure makes clear the treatment of success-based fees, the Service restricted its application in a subsequent technical memo. In CCA 201234027,4 the IRS National Office addressed the treatment of milestone payments and found that such payments did not qualify for the safe harbor. Thus, even though the safe harbor offered simplification, that simplicity was restricted by the Service interpretation.

The new directive provides relief to corporate taxpayers because LB&I examiners are instructed not to challenge the treatment of milestone payments paid to investment bankers in connection with a covered transaction when a safe harbor election is made. The directive is applicable to investment banking fees incurred by either an acquiring corporation or a target corporation. It does not apply to other success-based fees, (e.g., legal, consulting, or accounting fees.)

Because the safe harbor, once elected, must be applied to all success fees, it may be inferred that all other success fees will continue to be scrutinized at examination. Moreover, the directive is limited to amounts deducted on original timely filed returns and does not apply to claims or amended returns. Although this directive is appreciated, it falls short of the relief required by companies undergoing corporate transactions. Further, the directive serves as a reminder that a number of technical questions regarding the treatment of transaction costs remain unanswered.

Background - Treatment of Transaction Costs

Proper cost allocations are grounded in the "origin of the claim" doctrine, under which "the origin and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling basic test of whether the expense is deductible or not."5 In Woodward v. Commissioner,6 the Supreme Court applied the origin of the claim doctrine to corporate transaction costs, finding that the nature of the transaction governs whether an item is a deductible expense or a capital expenditure. Following the Court's rationale in Woodward, the Seventh Circuit in A.E. Staley Manufacturing Co. v. Commissioner7 applied an origin of the claim approach and permitted the taxpayer to allocate a lump-sum investment-banking fee between deductible and capital categories. In Wells Fargo & Co. v. Commissioner,8 the Eighth Circuit similarly followed the Supreme Court's precedent and allowed a taxpayer to deduct salaries and other indirect merger expenses. In addition, the Eighth Circuit held that the legal expenses incurred before the final merger decision date were deductible, and the remaining portion of the legal expenses after the decision date were required to be capitalized.

In Wells Fargo, thecourt relied on Rev. Rul. 99-239 to analyze the taxpayer's costs. Although technically limited to Section 195 and start-up expenditures, Rev. Rul. 99-23's conclusions that investigatory costs are amortizable as start-up expenditures is premised on the deductibility of such costs in the context of the operation of an existing business. The ruling finds that preliminary and investigatory costs are deductible while costs attributable to completing the transaction are not.

Against this background, the Section 263(a) Regulations incorporated the concepts developed in Wells Fargo and its predecessor cases. These Regulations provide that costs incurred while investigating one of ten specified transactions are facilitative"and thus capitalized and not deducted. With respect to certain transactions, "covered transactions," (e.g., stock acquisitions, business asset acquisitions, or acquisitive tax-fee reorganizations), investigatory costs may be deducted if the amount relates to activities performed on or after the decision to acquire.10 The Regulations list a number of inherently facilitative services that must be capitalized regardless of when they are performed, but for investigatory and other non-inherently facilitative costs incurred to pursue a covered...