In Chief Counsel Advice (CCA 201713010), the IRS has concluded that, when a regulatory agency approves a merger subject to certain conditions, the costs that the taxpayer incurs to meet those conditions "are not per se required to be capitalized under [Reg. Section] 1.263(a)-5 as amounts paid to facilitate a transaction."

Background

A holding company (Taxpayer), with subsidiaries that include regulated "C" companies engaged in a particular business, negotiated a merger with Company E, which held interests that included another regulated C company (Company H). To go forward with the merger, the parties needed the approval of the Regulatory Board. The Taxpayer and Company E eventually entered into a settlement with the state, city, and other interested parties in connection with the regulatory proceedings, and the Regulatory Board subsequently approved the merger subject to four conditions:

1. Each Company H customer must receive a rate credit of a specified amount. (Taxpayer made a capital contribution to Company H to fund the rate credit, and the credit was given to the customers.)

2. A specified amount must be contributed to a customer investment fund. (The fund was established to provide long-term benefits to Company H customers.)

3. A specified amount must be paid to the state.

4. A commitment must be made to contribute a specified amount each year to charitable organizations and for "traditional local community support" in the state.

When Company E merged into the Taxpayer in a stock-for-stock transaction, Company H became a wholly owned subsidiary of the Taxpayer.

Law and analysis

Although businesses may generally deduct ordinary and necessary business expenses under Section 162, amounts paid "for permanent improvements or betterments made to increase the value of any property" may not be deducted (Section 263(a)). In addition, amounts paid to "facilitate" certain transactions — including the taxpayer's acquisition of an ownership interest in a business — must be capitalized under Reg. Section 1.263(a)-5(a). The regulations explain that an amount is considered to have been paid to facilitate a transaction "if the amount is paid in the process of investigating or otherwise pursuing the transaction," a facts-and-circumstances determination. The regulations clarify that, in making this determination, "the fact that the amount would (or would not) have been paid but for the transaction is relevant, but not determinative." (Reg. Section 1.263(a)-5(b)(1).)

The Chief Counsel cites the preamble to the proposed regulations under Section 263(a), which further explains "the concept of costs that facilitate a transaction":

The facilitate standard is intended to be narrower in scope than a "but for" standard. Thus, some transaction costs that arguably are capital under a but-for standard, such as costs to downsize a workforce after a corporate merger (including severance payments) or costs to integrate the operations of merged businesses, are not required to be capitalized under a facilitate standard. While such costs may not have been incurred but-for the merger, the costs do not facilitate the merger itself.

The Chief Counsel noted that the examining agent working with the Taxpayer "appears to rely primarily on a but-for test to argue that the costs in question are capital expenditures under [Reg. Section] 1.263(a)-5." Even if the costs at issue were incurred expressly to obtain regulatory approval for the merger, however, the IRS (or Chief Counsel) states that "the mere fact that costs would not have been incurred but for the closing of a transaction identified in [Reg. Section] 1.263(a)-5(a) is not sufficient to determine that the costs facilitate the transaction."

Given the facts presented, the Chief Counsel concludes it does "not have sufficient information to determine whether Taxpayer incurred the costs at issue solely on account of the merger," in part because "most of the costs identified are in the nature of annual operating costs that a [company in the industry] would incur as part of its normal business operations." In addition, certain payments made by the taxpayer (required annual charitable contributions) and the possibility of taxpayer's receipt of intangible property (as a result of the requisite payments to the state) would not be considered amounts paid to facilitate a merger, the IRS noted.

The Chief Counsel also rejects an alternative argument in which the examining agent relies on the definition of "inherently facilitative" services in Reg. Section 1.263(a)-5(e)(2), which requires capitalization of certain costs of "obtaining regulatory approval." The agent asserted that, because approval of the Regulatory Board was required for the proposed merger to go forward, and the Taxpayer was required to pay certain costs as a condition of this approval, "these costs are included with the costs incurred in obtaining regulatory approval." The Chief Counsel memorandum clarifies that "costs of obtaining regulatory approval include the costs of preparing for and appearing before a regulatory board" and the phrase "should not be read so broadly that it includes any and all costs to address conditions that might be imposed by regulators." Under the facts, the costs that the Regulatory Board required the Taxpayer to pay as a condition of regulatory approval "appear to be in the nature of annual operating or investment expenses and not analogous to deal costs paid to service providers who assist with financing, investigating, documenting, or otherwise administratively facilitating the transfer of property."

Implications

Many companies undertaking transactions need to obtain approval from the Securities and Exchange Commission (SEC) and/or the Department of Justice and Federal Trade Commission under the Hart Scot Rodino (i.e., HSR approval). In addition, companies in regulated businesses, such as telecommunications, energy or insurance, must also obtain approval from federal or state regulators of those businesses. The costs of obtaining approval for a transaction to proceed from federal and state regulators are often significant.

While most practitioners view the costs of obtaining SEC approval and HSR approval as facilitative, many view the costs of obtaining approval from federal and state regulatory agencies that oversee a company's business as distinguishable. For example, the costs of obtaining such regulatory approval may have their origin in preserving the company's existing business license granted by the relevant regulatory agency. In addition, as in the CCA, a company's cost of fulfilling any conditions imposed by the relevant regulatory agency may qualify for current deduction as costs related to the day-to-day business of the combined business. In this regard, the CCA supports a position that certain costs of obtaining approval from agencies that oversee regulated industries are not necessarily facilitative of the transaction.

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