Tax Treatment of Reorganization Costs

Practising Law Institute Tax Strategies for Corporate Acquisitions, Dispositions, Spin-Offs, Joint Ventures, Financings, Reorganizations and Restructurings 2003

By Mark J. Silverman and Andrew J. Weinstein

Originally published June, 2003. To read this article in full, please go to the bottom of this page.

OVERVIEW

PART ONE - THE PRESENT LAW

1. COSTS FOR UNCONTESTED ACQUISITIONS

   1. Costs Incurred by Target Corporations: National Starch and INDOPCO

   2. Costs Incurred by Acquiring Corporations

   3. Costs Incurred by Shareholders

   4. Public Comments on INDOPCO

2. ABANDONED TRANSACTIONS

3. COSTS FOR CONTESTED ACQUISITIONS: HOSTILE TAKEOVER

   1. Resisting Unwanted Acquirers

   2. Redemptions of Stock

4. COSTS INCURRED IN DIVISIVE REORGANIZATIONS

   1. General Rule

   2. Divestiture Required by Law

   3. Future Benefits and the Application of INDOPCO

   4. Summary

5. COSTS ATTRIBUTABLE TO PROXY FIGHTS

6. EXAMPLES

   1. Example 1

   2. Example 2

   3. Example 3

   PART TWO - THE PROPOSED SECTION 263(a) REGULATIONS

1. BACKGROUND TO THE PROPOSED SECTION 263(a) REGULATIONS

   1. Public Comments on INDOPCO

   2. The Advanced Notice of Proposed Rulemaking (the "Advanced Notice")

   3. The Proposed Section 263(a) Regulations (the "Proposed Regulations")

2. GENERAL DISCUSSION OF THE PROPOSED REGULATIONS - PROP. TREAS. REG. 1.263(A)-4

   1. Organization of the Proposed Regulations

   2. Capitalization of Acquisition Costs - Prop. Treas. Reg Prop. Treas. Reg. 1.263(a)-4(c)

   3. Capitalization of Creation or Enhancement Costs - Prop. Treas. Reg. 1.263(a)-4(d)

3. CAPITALIZATION OF TRANSACTION COSTS - PROP. TREAS. REG. 1.263(a)-4(e)

   1. General Rule for Transaction Costs

   2. "Transaction" Defined

   3. "Restructuring" and "Reorganization" Defined

   4. "Facilitate" Defined

   5. Treatment of Capitalized Transaction Costs - Prop. Treas. Reg. 1.263(a)(-4(g)

   6. Post Proposed Regulations Developments

4. EXAMPLES

   1. Example 1 - Costs that Facilitate an Issuance of Stock

   2. Example 2 - Costs that Facilitate a Borrowing

   3. Example 3 - Costs that Facilitate a Corporate Acquisition

   4. Example 4 - Employee Compensation

   5. Example 5 - Integration Costs

   6. Example 6 - Compensation to Target's Employees

   7. Example 7 - Corporate Acquisition; Retainer

   8. Example 8 - Corporate Acquisition; Antitrust Defense Costs

1. Example 9 - Corporate Acquisition; Hostile Defense Costs

   10. Example 10 - Corporate Acquisition; Break Up Fees

   11. Example 11 - Corporate Acquisition; Break Up Fees to White Knight

       OVERVIEW1

       I. Deduction vs. Capitalization

   1. Section 162(a) of the Internal Revenue Code allows a deduction for all "ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. . . ."2

   2. Section 263, however, prohibits deductions for amounts "paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate." Such items must be capitalized.

   3. The line between what items may be deducted and what items must be capitalized has long been a question for debate in the tax field. See Thompson v. Commissioner, 9 B.T.A. 1342 (1928) (holding that expenditures for surveys, geological opinions, legal opinions, settlements of suits involving title to lands, and abstracts of title are not deductible as ordinary and necessary expenses, but are capital expenditures to be added to cost of property).

2. In INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992), the Supreme Court held that expenditures incurred by a target corporation in the course of a friendly takeover are nondeductible capital expenditures.

3. Although INDOPCO clarified the law as it pertains to target corporations in successful friendly takeovers, issues still remain regarding the deductibility of expenses related to the investigation of an acquisition, expenses related to failed or abandoned transactions, expenses related to fighting hostile takeovers, expenses related to searching for white knights, expenses related to divisive reorganizations, expenses related to proxy fights, and costs of obtaining financing to redeem shares to prevent a hostile takeover, among others. This outline addresses those issues.

4. This outline also addresses recently issued proposed regulations under section 263(a) (the "Proposed Regulations"), Reg. 125638-1 (December 19, 2002), which, among other things, are intended to clarify and simplify many of these issues, and which, when finalized, should diminish the applicability of much of the case law and IRS authorities discussed in this outline. See generally Prop. Treas. Reg. 1.263(a)-4.

   1. The Proposed Regulations provide bright-line rules that govern taxpayers' treatment of three different types of costs, including:

      1. The direct costs of acquiring, creating, or enhancing intangible assets;

      2. The indirect costs of acquiring, creating, or enhancing intangible assets; and

      3. The transaction costs associated with certain restructurings, reorganizations, and transactions involving the acquisition of capital.

   2. This outline primarily concerns the third-type of cost -- transaction costs incurred with respect to reorganizations, restructurings, and transactions involving the acquisition of capital. However, for the sake of clarity and completeness, this outline also will briefly discuss the Proposed Regulations that govern the direct and indirect costs of acquiring, creating, or enhancing intangible assets (i.e., the first and second type of cost).

5. Accordingly, PART ONE of this outline discusses the present law (i.e., statutes, case law, and relevant IRS authorities) applicable to the determination of the treatment of reorganization costs. PART TWO of this outline discusses the Proposed Regulations as they relate to this determination.

   PART ONE -- THE PRESENT LAW

1. COSTS FOR UNCONTESTED ACQUISITIONS

   A. Costs Incurred by Target Corporations: National Starch and INDOPCO

   1. Early Revenue Rulings

      1. In Rev. Rul. 67-125, 1967-1 C.B. 31, the Internal Revenue Service ("Service") held that legal fees for advice as to the tax significance of a potential reorganization must be capitalized.

         (i) The Service noted first that legal fees incurred for services performed in drafting a merger agreement must clearly be capitalized as incident to a reorganization, since the merger changes the capital structure of the corporation. Rev. Rul. 67-125, supra.

         (ii) The Service went on to explain that legal fees for advice as to the tax ramifications of such reorganization are "just as necessary in effecting a reorganization as those for the actual drafting of the reorganization agreement." Id.

      2. In Rev. Rul. 73-580, 1973-2 C.B. 86, the Service held that compensation paid for services performed by employees relating to reorganizations should be treated the same as fees paid for similar services performed by outsiders. Thus, under the analysis set forth in Rev. Rul. 67-125, supra, the portion of compensation paid to employees in connection with services relating to a reorganization must be capitalized.

   2. National Starch

      1. In National Starch and Chemical Corp. v. Commissioner, 918 F.2d 426 (3rd Cir. 1990), aff'g 93 T.C. 67 (1989), aff'd INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992), the Third Circuit, in affirming a Tax Court decision, held that a corporation must capitalize consulting fees, legal fees and other expenses incurred in deciding whether to accept a friendly takeover bid.

         (i) Unilever, the acquirer, was a United States company that was owned by a foreign company. Wanting to increase its United States revenues relative to its overall revenues, the foreign company directed Unilever to approach National Starch, one of Unilever's suppliers, to find out if National Starch would be interested in being the target of a friendly takeover. Unilever made it clear that they were only interested in a friendly takeover.

         (ii) To accommodate the principal shareholders of National Starch, the transaction was consummated in two steps.

         (a) In step one, shareholders of National Starch were given the opportunity to exchange each share of National Starch common stock for one share of nonvoting preferred stock of a newly formed subsidiary of Unilever. This transaction was intended to be tax free under section 351.3

         (b) In step two, a transitory subsidiary of the Unilever subsidiary was merged into National Starch, and any National Starch common not exchanged under step one was converted into cash (a "reverse subsidiary cash merger").

         (iii) National Starch hired independent investment bankers and attorneys to assist in valuations and to make sure the board of directors did not breach any fiduciary duties. In addition, National Starch incurred miscellaneous fees such as accounting, printing, proxy solicitation, and SEC fees in connection with the transaction. National Starch deducted these fees, but the Service argued that they should be capitalized.

      2. National Starch argued that the Supreme Court's holding in Commissioner v. Lincoln Savings & Loan Ass'n, 403 U.S. 345 (1971) established a rule that an expense is only a capital expense if a separate and distinct additional asset has been created or enhanced due to the expense.

         (i) Since there was no separate asset created under the merger, National Starch argued, the fees should not be capitalized. Thus, the corporation should be allowed to deduct the expenses under section 162(a).

         (ii) Furthermore, National Starch argued that Lincoln Savings specifically rejected looking to the presence of a future benefit to determine whether expenditures were ordinary and necessary.

      3. The Tax Court and Third Circuit in National Starch, however, disagreed with these arguments. The Third Circuit noted that Lincoln Savings did not establish a "separate and distinct asset" test, and that it is possible for an expense...