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IRS Extends Safe Harbor to Certain Milestone Payments for Acquisitions or Reorganizations


2/25/14

Synopsis
 
The IRS has expanded the definition of payments that may be deducted for success-based fees made to facilitate a business merger or acquisition. Although, as explained below, the IRS’ indication is not officially tax law and consideration should be given whether the taxpayer would be changing its method of accounting for these types of fees which may require IRS permission, taxpayers, including funds of private equity providers, may find the expansion of this definition very favorable in terms of tax deductions they would not have otherwise generated in a deal.
 
Issue
 
As a general rule, the amounts paid to facilitate a business acquisition or reorganization (i.e., a transaction) must be capitalized. “Success-based fees,” which are fees that are contingent on the successful closing of a transaction, generally must be capitalized under this rule if they were paid after April 8, 2011.
 
However, in 2011, the IRS said it would not challenge the tax treatment of these fees (i.e., IRS provided a “safe harbor”) for taxpayers that elected to capitalize 30% of these fees and then treated the other 70%  as fees not paid to facilitate a transaction and met certain other criteria. Treatment of the 70% of fees as not for facilitating a transaction would generally lead to a current year tax deduction of those fees.
 
After that, the IRS’ Large Business & International (LB&I) division issued some directives to its examiners concerning “milestone payments.” These generally are nonrefundable payments contingent on achieving certain milestones in a transaction (e.g., tentative agreement by the representatives or board of the other party). The most recent directive replaced the previous definition with the following: “an event, including the passage of time, occurring in the course of a covered transaction (whether the transaction is completed or not).” The result is that the revised definition is broader and may provide the safe harbor treatment for fees that otherwise would not have qualified for the safe harbor. 
 
A “covered transaction” is defined as:

  • A taxable acquisition of assets that constitute a trade or business,
  • Certain taxable acquisitions of an ownership interest in a business entity, or
  • Certain corporate reorganizations in which corporate stock or securities are distributed.
     

The financial statement impact of this tax development will depend upon numerous factors including whether the payor of the fees is the acquirer, the target, or the seller. However, corporations should consider the following in their work concerning the accounting for income taxes (ASC 740):

  • Will the difference between the book and tax treatment create a material book-tax difference and, if so, will it be a permanent or temporary difference? The latter does not affect the effective tax rate of the entity.
  • If the client has taken a position on the deductibility of the fees that required a “tax reserve,” does the directive provide sufficient basis for eliminating the tax reserve?
     

What Does CohnReznick Think?
In addition to the questions above concerning the financial statement impact, it is important that taxpayers remember that an LB&I directive is guidance for the LB&I division’s examiners. Not all taxpayers are examined by the LB&I division. Furthermore, a directive is not the tax law. Although a directive may reflect a view or practice of the IRS, directives are not explicitly listed as the types of tax authority to be considered to determine whether a tax return position has substantial authority and can avoid tax penalties. So, in evaluating a tax return position, taxpayers should be careful not to rely solely on the directive but take into account all the authorities relevant to the taxpayer’s particular facts, in favor of and against the taxpayer’s position.

To learn more about CohnReznick’s industries and practices, please visit our webpage.


Circular 230 Notice: In compliance with U.S. Treasury Regulations, the information included herein (or in any attachment) is not intended or written to be used, and it cannot be used, by any taxpayer for the purpose of i) avoiding penalties the IRS and others may impose on the taxpayer or ii) promoting, marketing, or recommending to another party any tax related matters.

This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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