The IRS released an LB&I Process Unit (the Process Unit) on transaction costs on July 18, 2018. In addition to explaining the transaction cost rules under Reg. Section 1.263(a)-5, the Process Unit provides a three-step process for examining transaction cost issues that LB&I recommends "as a best practice." Process Units are intended to serve as job aids and training materials for IRS staff, so the Process Unit provides helpful insight into how the IRS is instructing exam teams to review transaction costs and how they may interpret the transaction cost rules.¹

Background

Reg. Section 1.263(a)-5 contains rules requiring taxpayers to capitalize amounts paid to "facilitate" (within the meaning of Reg. Section 1.263(a)-5(b)) 10 transactions that are specifically identified. Transactions falling within the ambit of Reg. Section 1.263(a)-5 include: (1) an acquisition of assets that constitute a trade or business (whether the taxpayer is the acquirer or the target); (2) an acquisition by the taxpayer of an ownership interest in a business entity if, immediately after the acquisition, the taxpayer and the business entity are related within the meaning of Sections 267(n) or 707(b);² (3) an acquisition of an ownership interest in the taxpayer (other than an acquisition by the taxpayer of an ownership interest in the taxpayer, whether by redemption or otherwise); (4) a restructuring, recapitalization or reorganization of the capital structure of a business entity (including a reorganization described in Section 368 and a distribution under Section 355); (5) a transfer described in Section 351 or Section 721 (whether the taxpayer is the transferor or transferee); (6) a formation or organization of a disregarded entity; (7) an acquisition of capital; (8) a stock issuance; (9) a borrowing;³ and (10) writing an option.

Subject to certain exceptions,⁴ an amount is incurred to facilitate a transaction described in Reg. Section 1.263(a)-5(a) if the amount is incurred "in the process of investigating or otherwise pursuing" the transaction. Whether an amount is incurred in the process of investigating or otherwise pursuing the transaction is determined based on all of the facts and circumstances.

For analyzing transaction costs issues, the Process Unit sets forth a three-step process:

1. Proper legal entity. IRS agents should determine whether the taxpayer is the proper legal entity to take the transaction costs into account for tax purposes.

2. Facilitative costs. If the IRS agents determine the taxpayer is the proper legal entity for taking the transaction costs into account, the next step is to determine whether the costs facilitate the transaction and must be capitalized under Reg. Section 1.263(a)-5.

3. Treatment of facilitative costs. If the IRS agents determine the costs facilitate the transaction, IRS agents should determine how those costs should be treated.

Key takeaways from the Process Unit

1. Step 1: Proper legal entity

As outlined in the Process Unit, the first step to consider when analyzing transaction cost issues is whether the taxpayer is the proper entity to take the costs into account for tax purposes (location analysis). Transactions often involve multiple parties that incur transaction costs, and the party that pays the costs may not be the legal entity that incurs the cost. To illustrate this issue, the Process Unit provides the following example:

W, a US parent of a consolidated group that includes R, a wholly owned subsidiary, decides to sell its equity interest in R. W engages an investment banker on behalf of R to locate a buyer and negotiate the sale of R's stock. The investment banker negotiates an agreement under which J, a corporation, buys all of R's stock. R pays the investment banker a fee in connection with the transaction. In the example, the Process Unit explains that the investment banker's services must be analyzed to determine which entity must take the fee into account for tax purposes and whether all or a portion of the fee facilitates the acquisition of R's stock.⁵

The Process Unit provides a list of questions⁶ to consider when determining the proper legal entity to take the costs into account, which includes the following:

1. What service was provided?
2. On whose behalf was the service rendered?
3. To whom was the service rendered?
4. To whom did the service provider report?
5. Who directly benefitted from the service?
6. Who incurred the economic burden for the service?
7. Who paid for the service?

These factors are consistent with the factors considered in court cases and in IRS administrative guidance.

In our experience, however, it is not uncommon to see scenarios in which all of the location factors do not align. For example, one entity initially engages the service provider, a second entity is the legal acquirer and a third entity pays the costs of the service provider. We note the Process Unit does not address scenarios in which the location factors do not align.

The Process Unit also lists the documentation IRS agents may find helpful in determining which legal entity incurred the transaction costs. The Process Unit indicates that a taxpayer's written explanation of the activities performed by the service provider and the benefits realized by the parties taking the costs into account is sufficient documentation to show which legal entity incurred the costs. ⁷ In our experience, practitioners and taxpayers often use this type of supporting documentation.

A. Payments on behalf of another party

Regarding payments made on behalf of another party, the Process Unit explains that, under Reg. Section 1.263(a)-5(k), "an amount considered to have been paid by a party to the transaction includes an amount paid on its behalf by another party to the transaction." For a taxpayer to be treated as incurring a cost paid on its behalf, the taxpayer must have benefitted from the services for which the payment was made. It further explains that, if the taxpayer benefits from the services for which another party paid and does not reimburse the paying party, the amount paid should be treated as either a capital contribution or a distribution to the taxpayer and the taxpayer should be treated as using the funds to pay for the services.⁸

It is notable that the IRS recognizes the fiction that the taxpayer uses the funds to pay for the services in the context of a capital contribution or distribution. In our experience, some agents have questioned the treatment of an item when the party taking the costs into account is not the engaging party or the party paying the fee. While Process Units are not official pronouncements of law and cannot be relied on as such, they are a helpful resource to reference in support of this position.

To illustrate this concept, the Process Unit provides the following example:

X, a partnership, owns 75% of the stock of Y, a corporation; the remaining 25% of Y's stock is widely-held. In 2015, Merger Sub, a wholly-owned subsidiary of P, which is unrelated to X and Y, merges with and into Y, with Y surviving. In the transaction, P acquires all the stock of Y and Y becomes a subsidiary of P.

P arranges and pays for an investment banker and a law firm to provide financial advisory and legal services to Merger Sub and Y in connection with the transaction, including negotiating and structuring the transaction and preparing the merger agreement. The investment banker and law firm provided some services directly to Merger Sub and/or Y.

Other services provided by the investment banker and law firm directly benefitted Merger Sub and/or Y. The investment banking fees and legal fees for services provided to Merger Sub and Y should be allocated to and taken into account by either Merger Sub [or] Y, based upon the entity to which the services were rendered and/or on whose behalf the services were provided, even if P paid the fees for the services.⁹

This example illustrates that costs of service providers engaged by one party can be taken into account by another party (e.g., the acquirer's investment banker and legal fees may be taken into account by the target if certain factors are met). Also, aspects of the conclusion are interesting. First, transaction costs are not typically allocated to Merger Sub, as it is transitory in nature and disregarded for federal income tax purposes.¹⁰ Second, in certain circumstances when multiple parties benefit from the service provider's activities, the fee paid to the service provider is not always required to be allocated among the benefitting parties.¹¹

2. Step 2: Facilitative Costs

Under the Process Unit, the next step is to determine whether the costs facilitate the transaction and must be capitalized under Reg. Section 1.263(a)-5.

The Process Unit lists documentation that may be helpful in obtaining an understanding of the facts regarding transaction costs incurred.¹² Most notably, in addition to that list, the Process Unit suggests that IRS agents may interview the service providers' employees who performed the services to determine how the service providers spent their time and how the fees to those service providers should be allocated. In our experience, IRS agents have generally relied on the documentation provided and have not requested to speak to the service provider.

A. "But-for" the transaction

Under Reg. Section 1.263(a)-5(b)(1), the fact that a cost would (or would not) have been paid but for the transaction is relevant, but does not determine whether the amount facilitates the transaction. Regarding this concept, the Process Unit explains, "Costs [resulting] from the transaction are not facilitative costs. For example, when a taxpayer executes an IPO, it may be obligated to pay a fee to terminate a service agreement such as a management agreement. The fee to terminate the agreement is a fee for management services provided or compensation for foregone services that would have been provided if the IPO had not occurred. Since the termination fee is not a payment for services rendered in connection with the IPO, it is not incurred to investigate or otherwise pursue the IPO, does not facilitate the transaction and is not capitalizable under Reg. Section 1.263(a)-5."¹³ In our experience, certain IRS agents have questioned the application of the "but-for" rule.

Additionally, the Process Unit makes clear that costs that have their origin in Reg. Section 1.263(a)-4 are not facilitative of the transaction. For example, the Process Unit affirms that the cost of representation and warranty insurance required by the terms of the transaction agreement does not facilitate the transaction, but may be capitalizable as a cost to create the insurance contract under Reg. Section 1.263(a)-4.

B. Success-based fees

The discussion of success-based fees in the Process Unit is significant because it recognizes the use of the documentation rules under Reg. Section 1.263(a)-5(f) in lieu of the safe harbor election under Revenue Procedure 2011-29. Under Reg. Section 1.263(a)-5(f), success-based fees are "presumed to facilitate the transaction and must be capitalized." To rebut the presumption, a taxpayer may provide "sufficient documentation to support allocating some or all of the cost to activities that do not facilitate the transaction." But see CCA 201830011, in which the IRS denied a deduction for success-based fees for failing to meet the documentation requirements under Reg. Section 1.263(a)-5(f) (see Tax Alert 2018-1543).

Additionally, the Process Unit notes that Revenue Procedure 2011-29 allows taxpayers that incur success-based fees in connection with a covered transaction to elect to treat 70% of the success-based fees as not facilitating the transaction and capitalize the remaining 30%. The Process Unit states that "Revenue Procedure 2011-29 provides that the safe-harbor allocation election must be made by the extended due date of the original return."¹⁴ There is, however, no timeliness requirement in Revenue Procedure 2011-29 requiring a taxpayer to attach "a statement to its original federal income tax return for the [tax] year the success-based fee is paid or incurred" (emphasis added). The plain language of Revenue Procedure 2011-29, which only references an originally filed tax return, does not require the originally filed tax return to be timely filed.

Finally, the Process Unit acknowledges that, if the taxpayer fails to make a valid election, the taxpayer's only recourse is to request an extension of time to make the election under Reg. Section 301.9100.

C. Milestone payments

The Process Unit indicates that, based on LB&I Directives, Examination of Milestone Payments in the Acquisition of Businesses¹⁵ and Updated Guidance on the Examination of Milestone Payments in the Acquisition of Businesses¹⁶ (see Tax Alert 2013-0863), IRS agents should not challenge a taxpayer's treatment of a milestone payment, even if it is for an inherently facilitative service contained in Reg. Section 1.263(a)-5(e)(2). The LB&I Directive is not, however, authoritative guidance.

3. Step 3: Treatment of facilitative costs

A. Capitalization of stock issue costs

Reg. Section 1.263(a)-5(g) provides guidance regarding the treatment of costs that facilitate certain types of transactions; not all transactions described in Reg. Section 1.263(a)-5(a), however, are addressed and guidance is reserved for certain types of transactions. When the regulations do not provide guidance regarding the treatment of costs that facilitate certain types of transactions, other authorities govern the treatment of those costs. For example, the Process Unit explains that costs facilitating a stock issuance must be capitalized, and the capitalized costs are considered nondeductible capital outlays that reduce the inflow of capital and may not be deducted when incurred or upon dissolution.¹⁷ This treatment is consistent with our understanding of costs that are facilitative of stock issuances.

Other general takeaways from the Process Unit

The Process Unit indicates that a transaction may consist of multiple steps and each step may be a separate transaction in and of itself. If a taxpayer incurs lump-sum transactions costs, the taxpayer should allocate those costs among the different transactions.¹⁸

The Process Unit acknowledges that non-facilitative costs under Reg. Section 1.263(a)-5 are not necessarily deductible under Section 162. They may still be capitalizable under another provision of the Code, including Section 195, as start-up expenditures.¹⁹

The Process Unit lists a number of resources for IRS agents to review to identify transaction cost issues.²⁰ Those resources include:

— The taxpayer's schedules and statements attached to the return, SEC filings, news articles, and the taxpayer's website for disclosures and discussions of merger or acquisition transactions, new equity investments, public stock issuances and private placements, and new financing or option issuances

— Schedule M-3, Part III, lines 23 — 25 for current-year investment banking fees, legal, and accounting fees and other costs incurred for an acquisition or reorganization

— Form 1120, line 26, Other Deductions, for significant costs that could be related to a Reg. Section 1.263(a)-5(a) transaction (e.g., legal and professional fees, transaction advisory fees)

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ENDNOTES

¹ Practice Units are not official pronouncements of law or directives and cannot be used, cited or relied upon as such. Practice Units do not limit an IRS examiner's ability to use other approaches when examining issues. Practice Units and any non-precedential material (e.g., a private letter ruling, determination letter, or Chief Counsel advice) that may be referenced in a Practice Unit may not be used or cited as precedent.

² Reg. Section 1.263(a) covers an acquisition of an ownership interest that does not result in the taxpayer and the business entity being related within the meaning of Sections 267 or 707 (for example, an individual acquires less than 50% of the value of a corporation (see Section 267(b)(2)). Reg. Section 1.263(a)-4(c)(1)(i) specifically addresses the acquisition of an ownership interest in a corporation, partnership, trust, limited liability company, or other entity. Reg. Section 1.263(a)-4(d)(2)(i) addresses the creation of an ownership interest in a corporation, partnership, trust, limited liability company, or other entity. Reg. Section 1.263(a)-4(e) sets forth the rules for transactions costs for acquired or created ownership interests in a corporation, partnership, limited liability company, or other entity.

³ A borrowing means any issuance of debt, including an issuance of debt in an acquisition of capital or in a recapitalization. A borrowing also includes debt issued in a debt-for-debt exchange under Reg. Section 1.1001-3.

⁴ The primary exceptions to the capitalization requirement of Reg. Section 1.263(a)-5 are found in the "special rules" and "simplifying conventions" sections of Reg. Section 1.263(a)-5(c) and (d) and the special acquisitive transaction rules of Reg. Section 1.263(a)-5(e).

⁵ Page 5 of the Process Unit.

⁶ Page 16 of the Process Unit.

⁷ Page 17 of the Process Unit.

⁸ Page 11 of the Process Unit.

⁹ Page 14 of the Process Unit.

¹⁰ See, e.g., Revenue Ruling 73-427, 1973-1 C.B. 294; Revenue Ruling 78-250, 1978-1 C.B. 83; Revenue Ruling 79-273, 1979-2 C.B. 125; Revenue Ruling 90-95, 1990-2 C.B. 67.

¹¹ See e.g., Fall River Gas Appliance Co., Inc. v. Comm'r, 42 T.C. 850 (1964), aff'd, 349 F.2d 515 (1st Cir. 1965) (tie goes to the payer). In addition, when allocation among multiple parties is appropriate, it should be noted that Reg. Section 1.263(a)-5 contemplates that the parties benefitting from the transaction are also parties to the transaction. Therefore, allocation is only among the entities that engaged in the transaction and not among all the entities that may benefit from the transaction in some manner.

¹² Page 33 of the Process Unit (purchase and sale agreement or merger agreement; timeline or transaction calendar; engagement letters, and amendments thereto, for services provided; all correspondence, including emails, between service providers and the taxpayer during the relevant engagement period; minutes of meetings, including meetings between service providers, the taxpayer and other parties to the transaction, and meetings of the taxpayer's board of directors; copies of materials from presentations made by service providers to the board of directors or the officers of the taxpayer during the relevant engagement period; legal invoices, which can be used to construct a timeline for the transaction, if the taxpayer cannot or does not provide a timeline or transaction calendar; allocation spreadsheets developed by an accounting firm and the records the accounting firm relied on in determining the allocation).

¹³ Page 21 of the Process Unit.

¹⁴ Page 30 of the Process Unit.

¹⁵ I.R.S. LB&I Directive Control No. LB&I-04-0413-002 (April 29, 2013).

¹⁶ I.R.S. LB&I Directive Control No. LB&I-04-0114-001 (January 27, 2014).

¹⁷ Page 36 of the Process Unit.

¹⁸ Page 38 of the Process Unit.

¹⁹ Pages 21 and 23 of the Process Unit.

²⁰ Page 8 of the Process Unit.