INSIGHT: ‘Facilitative’ Merger Costs Don’t Create Separate Intangible Asset

A corporate taxpayer may have cut its losses when it sold an unprofitable acquisition, but it couldn’t deduct the capitalized professional and administrative fees.

The taxpayer claimed a loss for and deducted capitalized expenses incurred by the target when it was in the process of investigating a potential acquisition by the taxpayer. The taxpayer said the fees created or enhanced a separate and distinct intangible asset. The Internal Revenue Service determined that the taxpayer could not deduct these fees in Technical Advice Memorandum 202004010, released Jan. 24.

The taxpayer acquired the stock of the target corporation in a taxable reverse triangular merger. In announcing the acquisition, the taxpayer and the target stated that “the merger was intended to achieve cost synergies.”

In connection with the sale of its stock to the taxpayer, the target paid a total of $d in professional fees and administrative expenses. The target determined that $e of these fees and expenses were paid “in the process of investigating or otherwise pursuing” its acquisition by the taxpayer, and, therefore, were required to be capitalized. The target also determined that $f of the fees were “success-based fees” and the target utilized the safe harbor under Revenue Procedure 2011-29, to allocate those fees between facilitative costs (30%) and non-facilitative costs (70%), which may be deducted as business expenses under tax code Section 162. The taxpayer capitalized the $h in facilitative fees as an intangible asset on its tax books.

On Date 2, the taxpayer entered into a stock purchase agreement with a buyer to sell the target to the buyer. On Date 3, the taxpayer completed the sale resulting in an estimated capital loss of $i. On its consolidated income tax return for its year ending on Date 4. When calculating the separate taxable income of the target, the taxpayer claimed a Section 165(a) loss deduction for the target of $h representing the value of the fees capitalized under Section 263(a). The taxpayer reduced its basis in the target stock by a corresponding amount under the investment adjustment rules of Treasury Regulation 1.1502-32. This resulted in a reduced capital loss on the sale of the target. Thus, the taxpayer’s strategy had the effect of “converting” a difficult to deduct capital loss into a fully deductible “ordinary” loss. The Internal Revenue Service, however, ruled that this conversion could not be countenanced.

Separate and Distinct Intangible Asset

Treas. Reg. 1.263(a)-4(b)(1) provides that a taxpayer must capitalize an amount paid “to create or enhance a separate and distinct intangible asset.” Treas. Reg. 1.263(a)-4(b)(3)(i) provides that the term “separate and distinct intangible asset” means a property interest of ascertainable and measurable value in money’s worth that is subject to protection under applicable law and the possession and control of which is intrinsically capable of being sold, transferred, or pledged apart from a trade or business.

Treas. Reg. 1.263(a)-5 provides that a taxpayer must capitalize an amount paid to facilitate a transaction described in Treas. Reg. 1.263(a)-5(a). Treas. Reg. 1.263(a)-5(g) provides for the treatment of facilitative costs capitalized under Treas. Reg. 1.263(a)-5(a). Treas. Reg. 1.263(a)-5(g) expressly reserves on the treatment of a target’s facilitative costs in a taxable stock acquisition.

The first issue was whether fees paid by the target created or enhanced a separate and distinct intangible asset. The taxpayer agreed that the fees incurred by the target would not qualify as a separate and distinct intangible asset as expressly defined in Treas. Reg. 1.263(a)-4(b)(3)(i). Instead, the taxpayer argued that the target paid these amounts to create a separate and distinct intangible asset “in the form of the synergistic benefits that the target expected to receive from its combination with the taxpayer.” This asset became useless to the target at the termination of its relationship with the taxpayer.

The taxpayer contended that this conclusion was consistent with the Supreme Court’s analysis in INDOPCO Inc. v. Commissioner, which reasoned that professional expenses incurred by a target corporation in the course of a friendly takeover were required to be capitalized because of the synergistic benefits expected to be generated by the combination of the target and the acquirer’s business. The taxpayer contends that, in the target’s case, these synergistic benefits comprised a separate asset that is properly recoverable at the end of the asset’s useful life.

The IRS rejected this analysis. The fees paid by the target, it noted, were not amounts incurred to acquire or create a separate and distinct intangible under Treas. Reg. 1.263(a)-4, and were not capitalized under that section. Rather, Treas. Reg. 1.263(a)-5 would govern the application of Section 263 to the target’s costs, and under those provisions, these fees were properly capitalized by the target as the costs of facilitating an acquisition of the target’s business in accordance with Treas. Reg. 1.263(a)-5(a)(3), the IRS said.

IRS’s INDOPCO Analysis

The taxpayer correctly observed that Treas. Reg. 1.263(a)-5(g) specifically reserves, and therefore does not address, the treatment of the target’s costs capitalized in a taxable stock acquisition. The IRS believed that “longstanding case law, including the Supreme Court’s analysis in INDOPCO, is instructive.”

In INDOPCO, the court determined that certain professional costs incurred by a target corporation were required to be treated as capital expenditures. In its analysis, the court concluded that the creation of separate and distinct assets may be sufficient, but was not a necessary prerequisite for determining that a taxpayer must capitalize costs under Section 263. The court determined that a taxpayer’s expectation of significant future benefits from a corporate acquisition or restructuring is another appropriate basis to require capitalization under Section 263.

In its reasoning, the court made clear that the professional costs at issue were incurred for the restructuring of the target corporation, its continuing operations and betterment, for the duration of its existence, and not for the acquisition of an intangible asset that was separate and distinct from its ongoing business.

The taxpayer’s facts, the IRS said, “are analogous to the facts in INDOPCO and the same analysis and conclusion are warranted.” Thus, the fees paid by the target did not create or enhance a separate and distinct intangible asset but were incurred to facilitate a restructuring of the target’s trade or business. Consistent with INDOPCO, these facilitative costs are characterized “as the costs of acquiring significant future benefits for Target’s business and operations, and they would remain capitalized for the life of that business, generally, the duration of Target’s business enterprise” (emphasis added).

Loss Deduction

The second issue, the result of which was foreordained by the IRS’s conclusions with respect to the first issue, is whether the taxpayer properly claimed a loss deduction on behalf of the target under Section 165 for the target’s capitalized professional and administrative fees. The fees did not create or enhance an intangible asset separate and apart from the target’s business but rather were incurred to benefit the target’s business. A taxpayer would generally not be permitted to recover these costs until the dissolution of the business enterprise or until the occurrence of another event that ends the useful life of the business.

The taxpayer didn’t show that the target abandoned its business or that the target’s business operations were dissolved. In addition, the taxpayer didn’t provide any evidence that the target either subjectively determined or objectively manifested that its business was worthless. In fact, after the sale, the target continued to exist as a corporation and continued to operate its business under the buyer.

Accordingly, the target was not entitled to a loss under Section 165 for the taxable year in which its stock was sold by the taxpayer. Thus, as a practical matter, capitalized facilitative costs incurred in connection with a taxable stock acquisition are never deductible, even when the benefits sought from the transaction are determined to be inaccessible.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.