The IRS released an LB&I Transaction Unit (the Transaction Unit) on transaction costs in a corporate separation on May 10, 2019. In addition to explaining how the transaction costs rules under Reg. Section 1.263(a)-5 apply to corporate separations, the Transaction Unit provides a recommended framework for examining such issues. The Transaction Unit is intended to serve as both a job aid and training materials for IRS staff, so it provides helpful insight into how the IRS is instructing exam teams to review transaction costs in corporate separations and how they may interpret the applicable rules.¹

Background

Reg. Section 1.263(a)-5 (the Regulations) contains rules requiring taxpayers to capitalize amounts paid to "facilitate" 10 specifically identified transactions,² among which include "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." Subject to certain exceptions,³ 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 the facts and circumstances.

In a Section 355 transaction, a distributing corporation distributes the stock of a controlled subsidiary⁴ in a tax-free transaction (a corporate separation). A Section 355 transaction can take many forms, but some common structures, as illustrated in the Transaction Unit,⁵ include a distributing corporation either (1) distributing the stock of a controlled corporation pro rata to its shareholders (i.e., a spin-off); (2) distributing the stock of a single controlled corporation to one or more (but not all) shareholders in exchange for the distributing corporation's stock held by the receiving shareholder(s) (i.e., a split-off); or (3) distributing the stock of two or more controlled corporations to its shareholders in liquidation (i.e., a split-up). Additionally, a corporate separation may be executed as part of a divisive "D" reorganization under Section 368(a)(1)(D), in which a business is transferred to a newly-formed subsidiary and the new subsidiary's stock is distributed to some or all its shareholders.

Taxpayers engaged in corporate separations often incur significant costs in connection with the transaction including legal fees, accounting fees, consulting fees, investment banking fees, etc. The Transaction Unit sets forth a framework for auditing the treatment of such transaction costs, which includes reviewing the following potential issues:

1. Issue 1: In the year the corporate separation was completed, did the distributing corporation deduct transaction costs that facilitate the transaction?
2. Issue 2: In the year the corporate separation was completed, did the distributing corporation deduct costs it previously capitalized as facilitating the acquisition of the controlled corporation?
3. Issue 3: In the year the corporate separation was completed, did the controlled corporation deduct costs it previously capitalized as facilitating the acquisition of its stock?

Key takeaways from the Transaction Unit

1. Issue 1: Costs that facilitate the separation transaction

A. Non-facilitative costs

First, the Transaction Unit instructs exam teams to determine whether the distributing corporation deducted transaction costs that facilitated the transaction. Under Reg. Section 1.263(a)-5(b)(1), a cost facilitates a transaction "if the amount is paid in the process of investigating or otherwise pursuing the transaction." The Regulation further provides that "the fact that the amount would (or would not) have been paid but for the transaction is relevant, but is not determinative." The Transaction Unit explains, "[t]he foregoing definition of 'facilitate' is very broad and encompasses many costs." It goes on to provide examples of facilitative costs including, (i) investment banking fees for a fairness opinion regarding the corporate separation and (ii) costs to develop materials for soliciting and obtaining shareholder approval of the transaction.⁶

However, the Transaction Unit does not provide further explanation of the types of costs that would be non-facilitative. The definition of facilitate is not so broad as to encompass every expense that relates to a transaction. As noted above, the fact that an expense would not have been paid but for the transaction is relevant, but not determinative, of whether the expense facilitates the transaction. The courts and the IRS have routinely permitted taxpayers to deduct costs that are coincidental to, but do not have their origin, in the transaction. For example, costs that have their origin in the taxpayer's business operations, including general tax consulting, routine SEC filings, and corporate governance matters, are not facilitative of a capital transaction.

Additionally, Reg. Section 1.263(a)-5(c)(6) specifically provides that an amount paid to integrate the business operations of the taxpayer with the business operations of another does not facilitate a transaction, regardless of when the integration activities occur. While the rule for integration costs set forth in the Regulations appears to specifically contemplate only transactions where the business of one corporation is combined with another, costs analogous to integration costs are often incurred in the context of a Section 355 transaction. For example, costs to relocate personnel and equipment, provide severance payments, and adjust records and information systems may be paid in a corporate separation. The principle, which seems to underlie the treatment of integration costs in the Regulations - that such costs are coincidental to, but do not have their origin in the transaction, is not limited to acquisitive transactions. Therefore, in our view, integration costs are no less deductible in the context of a corporate separation transaction than in an acquisitive transaction.⁷

B. Facilitative Costs

Once it has been determined that an amount is required to be capitalized, the next questions are (1) to what is this amount capitalized and (2) how are such costs recovered? The Regulations do not address these issues in the context of a corporate separation, and the Transaction Unit does not provide much clarity either. While there is no clear guidance, there are at least three possible approaches: (i) the costs are added to the basis of the assets contributed to the controlled corporation; (ii) the costs increase the distributing corporation's basis in the stock of controlled corporation; or (iii) the costs are treated as a separate intangible. We believe the better view is that the capitalized costs are treated as a separate intangible as such costs were incurred in the alteration of the corporate structure for the benefit of future operations.⁸

Regarding the recovery of such costs, the Transaction Unit simply states, "[Reg. Section] 1.263(a)-5(g) … does not address costs that facilitate a corporate separation and other authorities do not support a recovery of such costs, unless the transaction is abandoned … Also, certain transaction costs capitalized for a reorganization may be deductible under Section 165 if the underlying property is abandoned or sold."

C. Section 162(k)

Although the issue is not discussed in the Transaction Unit, a question exists as to whether Section 162(k) impacts the potential recovery of capitalizable costs incurred in a corporate separation. Section 162(k) provides that no deduction is allowed for amounts paid or incurred by a corporation in connection with the reacquisition of its stock (a "stock reacquisition transaction"). While the term "stock reacquisition transaction" is arguably broad, we believe that it is limited to transactions that qualify as redemptions or as dividend equivalent redemptions under Section 302 and does not apply more broadly to any transaction that might, in form, involve a reacquisition of stock. This view is supported by the legislative history under Section 162(k). As originally enacted, Section 162(k) referred specifically to "redemptions"; however, the statutory language was subsequently changed to refer to "stock reacquisitions." The legislative history to Section 162(k) provides that the term "reacquisition" rather than "redemptions" was used to make sure that taxpayers could not argue that redemptions that are treated as Section 301 distributions were outside the purview of Section 162(k). As such, extending the application of Section 162(k) to Section 355 transactions would be beyond the scope for which the provision was enacted.

Further, not all Section 355 transactions, in form, involve a stock reacquisition. In the examples of Section 355 transactions described above, a spin-off does not involve a reacquisition of its stock by the distributing corporation whereas a split-up and split-off do involve such a reacquisition. As such, the applicability of Section 162(k) would differ based on the form of the transaction. There is no reason to apply Section 162(k) to certain Section 355 transactions and not others based on a formalistic approach.

2. Issue 2: Facilitative costs the distributing corporation capitalized when it acquired the controlled corporation's stock in a tax-free transaction

The second issue addressed in the Transaction Unit is determining whether the distributing corporation deducted transaction costs that it previously capitalized as facilitating the acquisition of the controlled corporation. The Transaction Unit provides an example to illustrate this issue: Distributing corporation acquired the stock of controlled corporation in Year 1 in a tax-free reorganization under Sections 368(a)(1)(A) and 368(a)(2)(E). Distributing corporation capitalized the facilitative costs it incurred in connection with the transaction in Year 1. In Year 6, distributing corporation separates the controlled corporation from its other trades or businesses in a spin-off transaction under Section 355.

In Year 6, the question arises as to how the distributing corporation should treat the facilitative costs that it capitalized in Year 1? The introductory "Issue and Transaction Overview" on page 3 of the Transaction Unit states, "[u]nder current law, transaction costs incurred by the distributing corporation that facilitated its acquisition of the controlled corporation's stock may not be recovered until the controlled corporation dissolves. See, e.g., INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992). In a corporate separation, the controlled corporation does not dissolve; rather, its stock is distributed to shareholders of the distributing corporation."

Notably, the discussion in the Transaction Unit is vague and the proper treatment of such costs in Year 6 remains unclear. For example, it provides examiners with various issues to consider, but does not provide a conclusive answer. For example, it instructs examiners to consider whether (1) the distributing corporation abandoned the controlled corporation's stock when it distributed such stock in the corporate separation and (2) the corporate separation caused distributing corporation to sustain a loss under Section 165.

Interestingly, this example appears to be based on the assumption that the previously capitalized costs are a separate non-amortizable intangible. However, note that Reg. Section 1.263(a)-5(g)(1) is reserved and does not provide guidance regarding the treatment of costs capitalized as facilitating a tax-free transaction described in Reg. Section 1.263(a)-5(a)(4), which includes a reorganization under Section 368(a)(1).

Finally, the example only focuses on costs that were previously capitalized in a tax-free reorganization, but does not address the proper treatment of capitalized costs if the controlled corporation was previously acquired in another type of transaction. The treatment and recovery of capitalized costs varies based on the type of transaction.

3. Issue 3: Facilitative costs the controlled corporation capitalized when the distributing corporation acquired its stock

The third issue addressed in the Transaction Unit is determining whether the controlled corporation deducted costs it previously capitalized as facilitating the distributing corporations acquisition of its stock. In the same example described in Issue 2 above, the controlled corporation capitalized the facilitative transaction costs incurred in connection with the transaction in Year 1. Again, the Transaction Unit is vague and does not provide conclusive guidance on the proper treatment of such costs in Year 6 (i.e., the year of the corporate separation). Instead, it cites authorities for examiners to consider.

Specifically, it cites INDOPCO, Inc. v. Commissioner,⁹ in which the court stated, "a capital expenditure is amortized and depreciated over the life of the relevant asset, or, where no specific asset or useful life can be ascertained, is deducted upon dissolution of the enterprise." Additionally, it references TAM 200502039, in which the IRS stated that the target of a prior acquisition could not deduct, as an abandonment loss under Section 165, costs it previously capitalized as facilitating its acquisition upon its dissolution under state law where prior to its dissolution, the target distributed its assets to another member of its affiliated group in liquidation. The IRS reasoned the resource and synergy benefits between the target's business enterprise and the acquirer's business enterprise continue to exist so long as the target's business continues to exist, and a dissolution of the charter does not terminate such benefits.

Based on the foregoing authorities, the Transaction Unit instructs examiners to consider the following when determining whether the controlled corporation is entitled to deducts costs it previously capitalized as facilitating the acquisition of its stock: (1) whether the controlled corporation dissolved in the corporate separation; (2) whether the synergistic and resource benefits associated with the controlled corporation's affiliation with the distributing corporation terminated in the corporate separation; and (3) whether the corporate separation caused the controlled corporation to sustain a loss under Section 165 with respect to the previously capitalized costs.

Additional considerations and implications

The release of the Transaction Unit follows the March 13, 2018 announcement of a new LB&I campaign on costs facilitating a Section 355 transaction (see Tax Alert 2018-0628). The release of the Transaction Unit, in conjunction with the LB&I campaign, shows a continued interest by the IRS on transaction costs incurred in corporate separations. With the potential for increased scrutiny by the IRS on corporate separations, taxpayers will need to be even more thoughtful about performing an analysis of their transaction costs. For example, taxpayers should seek to thoroughly support their positions taken with respect to non-facilitative separation costs for eligible transactions.

The recent interest by the IRS on transaction costs in corporate separations is noteworthy because such transactions may not be as common as other types of capital transactions. With that said, the transaction costs incurred in corporate separations are often significant. As discussed above, while a Section 355 transaction is not a "covered transaction" (covered transactions are afforded more favorable tax rules, such as application of the "bright-line date" rule, election of the safe harbor under Revenue Procedure 2011-29, etc.), not all the associated costs are facilitative and required to be capitalized.

Additionally, as noted above, there has been very little guidance issued by the IRS in this area. Because Practice Units are intended to serve as job aids and training materials for IRS staff, it provides helpful insight into how the IRS is instructing exam teams to review transaction costs in corporate separations and how they may interpret the transaction costs rules.

Finally, it's important to note that the impact on accounting methods may differ based on the form of the transaction in a corporate separation. Taxpayers should consult with a tax practitioner as the accounting methods implications are fact specific.

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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 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); (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; and (10) writing an option.

³ 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).

⁴ A distributing corporation "controls" a subsidiary corporation if the distributing corporation owns stock of the subsidiary with at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of the subsidiary's stock.

⁵ See pages 5-8 of the Transaction Unit.

⁶ See page 14 of the Transaction Unit.

⁷ See also, Tax Alert 2018-1770, discussing the LB&I Process Unit on Transaction Costs, in which the IRS recognizes the deductibility of certain costs that would not have been incurred "but for" the transaction.

⁸ By analogy, courts have characterized costs incurred in a tax-free reorganization as costs incurred in the alteration of the corporate structure for the benefit of future operations. McCrory Corp. v. United States, 651 F.2d 828, 832 (2nd Cir. 1981) ("The requirement that reorganization expenses be capitalized is consistent with the principle that organization costs are capital expenditures. This rule is supported by the judicial reasoning that such reorganization expenditures, like organization expenditures, contribute to the creation of an intangible long-term asset, namely 'a change in the corporate structure for the benefit of future operations.'")

⁹ 503 U.S. 79 (1992).