The IRS ruled in PLR 201736002, that a support payment made to induce an unrelated party to merge with the taxpayer's client is a deductible ordinary and necessary business expense under Section 162 and is not required to be capitalized under Section 263.

Facts

Taxpayer is an LLC that manages Acquirer, an unrelated entity, through an investment management agreement (IMA). Under the IMA, Taxpayer receives a base management fee, which is a percentage of Acquirer's total assets, and additional fees. The IMA continues as long as Acquirer approves annually. The IMA may, however, be terminated at any time upon 60 days written notice by a vote of the stockholders holding a majority of the outstanding voting securities of Acquirer, by a vote of Acquirer's directors, or by Taxpayer.

Subject to the approval of Target's shareholders, Acquirer undertook a taxable acquisition of Target's stock, resulting in Acquirer indirectly acquiring all of Target's assets. As a result of the merger, Taxpayer expects future fees under the IMA to increase because of Acquirer's increase in asset size. In connection with the merger, Taxpayer paid Target's shareholders a payment per share (the Support Payment). Taxpayer received no stock, cash, property or any other consideration from Target, Acquirer, or their shareholders, employees or affiliates in exchange for the Support Payment. The Support Payment was intended by Taxpayer to induce Target's shareholders to approve the merger. According to Taxpayer, investment advisors commonly provide financial inducements to attract and retain investors in entities that they advise.

Rulings

Support Payment is deductible

Section 162 generally allows taxpayers to deduct all ordinary and necessary business expenses. The Service determined that the Support Payment was ordinary, as Taxpayer represented that such financial inducements are common in the industry. The Service further determined that the Support Payment was necessary, as Taxpayer made it with the hope of business development and financial return. Were the merger to succeed, Acquirer's total assets would increase, thereby increasing the investment advisory fees paid to Taxpayer. Accordingly, the Support Payment is deductible as an expense under Section 162(a), subject to the capitalization rules of Section 263(a), for the creation or acquisition of intangibles.

Support Payment not required to be capitalized

Treas. Reg. Section 1.263(a)-4(c)(1) requires taxpayers to "capitalize amounts paid to another party to acquire any intangible from that party in a purchase or similar transaction." Taxpayer received no stock, cash or any consideration from Target, Acquirer, or their shareholders, employees, or affiliates for providing the Support Payment; therefore, it did not pay Target's shareholders to acquire any intangible from Target. As such, the Service determined the Support Payment is not an amount paid to acquire an intangible.

Treas. Reg. Section 1.263(a)-4(d)(6)(i)(B) requires capitalization of "amounts paid to another party to create, originate, enter into, renew, or renegotiate with that party an agreement providing the taxpayer the right to provide or receive services (or the right to be compensated for services regardless of whether the taxpayer provides such services)." By paying the Support Payment to Target's Shareholders, the Service ruled, Taxpayer was not "creating, originating, entering into, renewing, or renegotiating" with Target or its shareholders an agreement granting the right to provide or receive services or to be compensated for services. The IMA was with Acquirer, not Target's shareholders, and Taxpayer received nothing in return for paying the Support Payment. Additionally, Taxpayer made the payment in hope and "expectation of developing or maintaining a business relationship" with Acquirer, and the Support Payment was not contingent on the "origination, renewal, or renegotiation" of the IMA. Further, as the IMA can be terminated with 60 days' notice (terminable at will), it does not guarantee Taxpayer the right to provide or receive services. Accordingly, the Support Payment did not create an intangible required to be capitalized under Treas. Reg. Section 1.263(a)-4(d).

For the same reasons, the Support Payment did not "create or enhance a separate and distinct intangible" requiring capitalization under Treas. Reg. Section 1.263(a)-4(b)(3). Similarly, the Support Payment did not "facilitate the acquisition or creation of an intangible" under Treas. Reg. Section 1.263(a)-4(e) because no intangible was acquired or created by the payment. Finally, the Support Payment was not paid to facilitate any of the transactions listed in Treas. Reg. Section 1.263(a)-5(a).

Accordingly, the IRS determined that the Support Payment is not required to be capitalized under Section 263.

Implications

The conclusion in the PLR indicates that the form of the transaction or agreement (i.e., the taxpayer's role in the transaction or agreement) is an important factor when analyzing the proper treatment under Treas. Reg. Section 1.263(a)-4 and 1.263(a)-5 of costs paid by the taxpayer.

While the Taxpayer made the Support Payment to Target's shareholders to induce them to approve a capital transaction (i.e., Acquirer's acquisition of Target), the amount was not paid to "facilitate" a transaction as described in Treas. Reg. Section 1.263(a)-5 because Taxpayer was not a party to the merger agreement with Target. This conclusion rests on the distinction, legally and substantively, between a private equity management company (which here and often does not hold equity in portfolio companies) and the actual acquirer. The IRS could not have reached its conclusion if it did not respect this distinction, which is often critical in the analysis of transaction costs outside the context of the fact pattern addressed.

Additionally, the amount paid to Target's shareholders was not paid by Taxpayer to acquire an intangible from Target under Treas. Reg. Section 1.263(a)-4(c) because Taxpayer did not receive anything from Target's shareholders in exchange for the Support Payment. Similarly, the Support Payment was not paid to create an intangible under Treas. Reg. Section 1.263(a)-4(d). Specifically, the PLR focused on whether the Support Payment was paid to "create, originate, enter into, renew, or renegotiate" an intangible described in Treas. Reg. Section 1.263(a)-4(d)(6)(i)(B) (relating to an agreement providing the taxpayer the right to provide or receive services (or the right to compensation regardless of services performed)). Although the IMA could be potentially be viewed as an agreement described in Treas. Reg. Section 1.263(a)-4(d)(6)(i)(B), the Support Payment was not made to Acquirer (the other party to the IMA), but to Target's shareholders. As with the conclusions regarding Treas. Reg. Sec. 1.263(a)-5, this conclusion also rests on the identity of the legal entity receiving the payment.

———————————————