The CPA Journal

Tax Treatment of Merger and Acquisition Costs

By Paul J. Streer and Caroline D. Strobel

The Supreme Court decision in Indopco (112 SCT 1039) has had a far-reaching influence on the capitalization of costs that had previously been expensed.

The facts of the case are familiar: Indopco, Inc., formerly known as National Starch and Chemical Corporation, was a Delaware corporation that manufactured and sold adhesives, starches, and specialty chemical products. Unilever United States expressed interest in acquiring National Starch in a friendly transaction. The owners of National Starch agreed to the takeover under the condition that the transaction be tax-free.

A reverse subsidiary cash merger was devised and two new entities were created: National Starch and Chemical Holding Corp., a subsidiary of Unilever, and NSC Merger, Inc., a subsidiary of Chemical Holding that would have only a transitory existence. In an exchange designed to be tax-free under section 351, Chemical Holding exchanged one share of its nonvoting preferred stock for each share of National Starch common stock. Any National Starch common stock that was not so exchanged would be converted to cash in a merger of NSC Merger into National Starch. In order to assure that the transaction would be fair to the shareholders, National Starch engaged Morgan Stanley & Co., Inc., to evaluate its shares, render a fairness opinion, and generally assist in the event of a hostile tender offer.

Unilever’s final offer was $73.50 per share. A favorable private letter ruling was obtained from the IRS. The transaction was consummated the following year.
Morgan Stanley charged National Starch a fee of $2,200,000, along with $7,586 for out-of-pocket expenses and $18,000 for legal fees. The advising law firm charged National Starch $490,000, along with $15,069 for out-of-pocket expenses. National Starch also incurred miscellaneous expenses aggregating $150,962. No issue was raised as to the propriety or reasonableness of these charges. On its federal tax return for the short taxable year, National Starch deducted the $2,225,586 paid to Morgan Stanley, but not the other expenses. Upon audit, the IRS disallowed this deduction and issued a notice of deficiency. National Starch sought redetermination in Tax Court and asserted their right to deduct the investment banking fees and expenses as well as the legal and miscellaneous expenses.

The Tax Court ruled that the expenses were capital in nature and therefore not deductible as ordinary and necessary expenses under IRC section 162. The United States Court of Appeals for the Third Circuit affirmed, upholding the Tax Court’s findings that “both Unilever’s enormous resources and the possibility of synergy arising from the transaction served the long-term betterment of National Starch.” The court rejected the argument that the disputed expenses did not create or enhance a separate and distinct additional asset.

The Supreme Court found that the creation of a separate and distinct asset might be a sufficient condition for classification as a capital expenditure, but not a necessary condition. They further found that reliance on a future benefit is not sufficient to distinguish an ordinary business expense from a capital expenditure. Thus, the Supreme Court upheld the lower court’s opinion and distinguished the result from Lincoln Savings & Loan Assn. (SCt 403 US 345).

The Supreme Court explicitly stated that in order for a cost to be capitalized instead of expensed there does not necessarily have to be any future benefit, although in the case of National Starch there certainly was one. Furthermore, the question of whether to capitalize or expense a cost does not necessarily depend upon whether a separate and distinct asset has been created. The court found that the ability to expense a cost under section 162 is a right and that other costs should be capitalized, although a list of these costs in the code was not exhaustive.

Norwest Corporation

Norwest [Norwest Corporation and Subsidiaries, Successor in Interest to Davenport Bank and Trust Company and Subsidiaries v. Comm’r (112 TC 89)], a bank holding company founded in 1929, was a parent of an affiliated group of corporations and filed a consolidated federal income tax return. The IRS extended its application of the Indopco reasoning to include other types of costs in this case.

Bettendorf Bank was a member of Norwest Consolidated Group and conducted business from its main office in Bettendorf, Iowa, and two branches, one in Bettendorf and the other in Davenport, Iowa. DBTC, an Iowa state bank that before the transaction provided banking and related services to a four-city area consisting of Davenport, Bettendorf, Rock Island, Ill., and Moline, Ill., filed a consolidated federal income tax return with two wholly owned subsidiaries. DBTC stock was thinly traded in the Davenport over-the-counter market. The founding family owned 32.2% of the stock.

Norwest and DBTC began merger talks in 1990. The law firm of L&W was retained and investigated DBTC’s ability to fit in with Norwest and its affiliates and the effect the acquisition would have on the community. In June 1991, DBTC’s board of directors authorized three of its executive officers to negotiate with Norwest. These officers were also to hire legal and other representatives whose purpose would be to recommend to DBTC’s board a letter of intent between DBTC and Norwest. The board also appointed a special committee to perform an independent due diligence review, provide professional advice, and report to the board on the fairness and appraisal of the transaction.

On July 22, 1991, DBTC agreed to become a wholly owned subsidiary of Norwest and Norwest issued a press release to that effect. DBTC incurred many expenses that it deducted on its 1991 federal income tax return, including L&W legal expenses of $474,018 for services rendered ($460,000) and disbursements made ($14,018). The IRS disallowed this deduction and contended that it should have only been for $111,270. Of the $111,270, $83,450 was for services rendered and disbursements before July 21, 1991, when the transaction was still under consideration. The portion related to negotiating price, working on the fairness of the opinion, and satisfying securities law requirements was deemed deductible as an ordinary and necessary business expense. The remainder of the expenses for the due diligence review was disallowed.

An amount of $4,120 was related to L&W’s investigation of the sufficiency of Norwest’s director and officer liability coverage to protect DBTC’s directors and officers following the transaction for acts and omissions occurring beforehand. DBTC’s liability coverage policy expired on January 23, 1992. Norwest agreed to pay for insurance until at least January 18, 1995, to protect DBTC’s directors and officers against acts and omissions occurring before January 19, 1992, the effective date of the transaction.

During 1991, DBTC had 9 executives and 73 other officers working on various aspects of the transaction. None of the officers were hired specifically to render services on the transaction; all were hired to conduct DBTC’s day-to-day banking business. DBTC’s participation in the transaction had no effect on the salaries paid to its officers. Of these salaries, $150,000 was attributable to services performed in the transaction. DBTC deducted the entire salaries, including the $150,000, on its 1991 Federal income tax returns.

Norwest expanded the reach of Indopco by requiring the capitalization of the target corporation’s officers’ salaries in a friendly acquisition. The taxpayer argued that the officers’ salaries were ordinary and necessary business expenses because the officers working on the transaction were only involved tangentially in the merger, while their time was primarily spent carrying out their ordinary duties. They further argued that legal fees were deductible because they were primarily for investigation and due diligence services mostly performed before entering the transaction.

The Tax Court found that the target’s expenses provided a future benefit and should be capitalized. The court also disallowed the $150,000 deduction of officers’ salaries because, although no incremental cost was incurred, this activity pertained to the merger. This was a clear expansion of the rules regarding cost capitalization, as it required costs normally expensed to be segregated and capitalized insofar as they pertained to a corporate reorganization.

Dana Corporation

Recently, the United States Court of Appeals for the Federal Circuit reversed a Federal Claims Court finding [Dana Corporation v. U.S., 38 Fed. Cl. 356 (1977)], further upholding the expansion of the scope of acquisition expenses required to be capitalized. In Dana Corporation v. U.S. (83 AFTR 2d Para. 99-611, No. 98-50), the Court found that a legal retainer applied to offset the legal expenses actually incurred in a corporate acquisition must be capitalized.

Dana had paid the nonrefundable retainer to a law firm for a number of years. In several of these years, Dana did not use the services of the law firm at all. In three prior years, however, the law firm had billed for capital acquisition costs. In 1984, the law firm incurred $265,000 of fees in conjunction with Dana’s acquisition of another corporation. As provided in the retainer agreement, the $100,000 retainer amount was offset against the fees incurred. Consistent with prior years’ treatment, Dana capitalized the $165,000 differential and deducted the $100,000 retainer amount. The Claims Court, however, found that the retainer was in part to prevent the law firm from representing Dana’s competitors and, as a recurring item, could be currently deducted. The court reasoned that the retainer would have been paid without regard to the acquisition and attendant legal fees.

The Appeals Court disagreed, finding that the actual use of the fees in a particular year determined their current deductibility, rather than a pattern established in prior years. It found that the IRS’s characterization of the retainer as an advance deposit on the future legal costs for a capital acquisition was appropriate. Because the retainer agreement clearly provided for the right of offset against any actual fees incurred, the Appeals Court found that the actual use of the retainer fee should control the tax treatment. Given these facts, it was clear to the court that the use of the retainer was a reduction in the otherwise payable, non-deductible fees due for legal services rendered in conjunction with a capital acquisition. Consequently, the Appeals Court reversed the Claims Court and held that the retainer amount was not currently deductible as an ordinary and necessary business expense.

Cost of Purchased Workforce

In Field Service Advice 1999-841, the IRS reaffirmed its bias toward the capitalization of all costs incurred in connection with merger transactions and its resistance to a shortened amortization period. In the stated fact pattern, the acquiring taxpayer (a publisher) attempted to specifically attribute a significant portion of the target acquisition price to the value of the employment relationship with its editor-in-chief. The publisher then attempted to amortize the value assigned to the employment relationship of the acquired publication over a period of expected benefit. Although the employee was only under contract for another 35 months after the acquisition, the taxpayer projected an economic value over a 14-year (168-month) period.

Relying heavily on the Tax Court’s logic in Ithaca Industries Inc. v. Comm’r [97 T.C. 253 (1991), appeal docketed, No. 92-1045 (4th Cir. December 10, 1991)], the IRS indicated that it would disallow all separately identified amortization of the allocated value attributable to the 133-month post-contractual period. It argued that the employment relationship involved and its value were inseparable from goodwill or going concern value of the purchased business (which is amortizable over 15 years under IRC section 197). According to the IRS, the projected employment relationship with the editor-in-chief was the essence of going concern value, but any one employee is merely part of a larger asset, an assembled workforce, which has no ascertainable useful life.

In addition, the IRS considered the specific useful life assigned to the post-contractual employment relationship with a single individual for valuation purposes to be suspicious. Future employment choices are very unpredictable. Consequently, the IRS’s position was that reasonable and verifiable estimates of the actual duration of the employment relationship could not be made.

Start-Up Costs

Revenue Ruling 99-23 [I.R.B. 1999-20,3 (April 30,1999)] seeks to differentiate amortizable start-up costs under IRC section 195 from capitalizable costs under the rationale of Indopco. The ruling indicates that expenditures incurred in an attempt to acquire specific businesses are not start-up expenditures because they are capital in nature and not subject to amortization. In contrast, expenditures incurred in the course of generally searching for an active trade or business are investigatory and amortizable under IRC section 195. The ruling provides three examples.

Example 1. In April 1998, U hired an investment banker to evaluate the possibility of acquiring a trade or business unrelated to U’s existing business. The investment banker conducted research on several industries and evaluated publicly available financial information relating to several businesses. Eventually, U narrowed its focus to one industry. The investment banker evaluated several businesses within the industry, including corporation V and several of V’s competitors. The investment banker then commissioned appraisals of V’s assets and an in-depth review of V’s books and records in order to determine a fair acquisition price. On November 1, 1998, U entered an acquisition agreement with V to purchase all the assets of V. U did not prepare and submit a letter of intent, or any other preliminary agreement or written document evidencing intent to acquire V, before executing the acquisition agreement.

In this example, the IRS states that an examination of the nature of the costs incurred indicates U made its decision to acquire V after the investment banker conducted research on several industries and evaluated publicly available financial information. The costs incurred to conduct industry research and review public financial information are typical of a general investigation. These are investigatory costs and are eligible for amortization as start-up costs under IRC section 195. The costs incurred to evaluate V and its competitors also may be investigatory costs, but only to the extent they were incurred to assist U in determining whether to acquire a business and which business to acquire. If the evaluation of V and its competitors occurred after U had made its decision to acquire V, such evaluation costs are capital acquisition costs and not amortizable.

Example 2. In May 1998, W began searching for a trade or business to acquire. W hired an investment banker to evaluate three potential businesses and a law firm to begin drafting regulatory approval documents for a target. Eventually, W decided to purchase all the assets of X and entered into an acquisition agreement on December 1, 1998.

In this example, the costs incurred to evaluate potential businesses are investigatory and eligible for amortization as start-up expenditures under IRC section 195 to the extent they relate to whether and which business to acquire. The costs incurred to draft regulatory approval documents prior to the time W decided to acquire X are not, however, start-up expenditures under IRC section 195. The costs related to such activities, even if they occurred during the general search, were not incurred in order to investigate whether and which business to acquire, but rather to facilitate an acquisition.

Example 3. In June 1998, Y hired a law firm and an accounting firm to assist in the potential acquisition of Z by performing certain services labeled as preliminary due diligence, which included conducting research on Z’s industry and competitors and analyzing Z’s financial projections for 1998 and 1999. In September 1998, at Y’s request, the law firm prepared and submitted a letter of intent to Z. This offer resulted from prior discussions between Y and Z, and specifically stated that a binding commitment would result only upon execution of an acquisition agreement. Thereafter, the law firm and accounting firm continued to provide services labeled as due diligence, including a review of Z’s internal documents regarding insurance policies, employee agreements, and lease agreements, an in-depth review of Z’s books and records, and preparation of an acquisition agreement. On October 10, 1998, Y entered an acquisition agreement to purchase all the assets of Z.

In this example, an examination of the nature of the costs incurred by Y indicates that Y made its decision to acquire Z in September 1998, around the time when the law firm prepared the letter of intent. The costs related to the preliminary due diligence services provided before that time are typical costs incurred during an investigation of whether and which business to acquire. Thus, these costs are investigatory and eligible for amortization as start-up expenditures under IRC section 195. The cost of due diligence services provided after that time, however, relates to the attempt to acquire the business and must be capitalized under IRC section 263 as acquisition costs.

Start-Up Expenditures Defined

Letter Ruling 199901004 [Sept. 28, 1998 (TAM-48536-96)] provides further guidance. The government’s position is that IRC section 195(c)(1)(B) limits the amortization of start-up costs to those that would otherwise be deductible as ordinary and necessary business expenses except that the “carrying on of a trade or business” requirement has not been met. Two tests must be met: First, the expenditures must be paid or incurred for the creation of a new business or for the investigation of a business acquisition the taxpayer enters into. Second, the expenditure must be deductible if incurred in an existing trade or business rather than a capital expenditure.

The ruling also identifies the point when a decision is made to acquire a business, without regard to the taxpayer’s ultimate success in negotiating the acquisition, as the dividing line between investigation and acquisition efforts. Costs incurred for acquisition purposes must be capitalized. Expenses incurred in the course of a general search for or preliminary investigation of a business or investment include those expenses related to the decisions whether and which transaction to enter into. Once a specific business or investment has been selected, expenses incurred in an attempt to acquire the business or investment are capital in nature.

Analysis

The Indopco rationale has been expanded to include costs that normally would be expensed in contexts other than corporate mergers. The decision in Norwest should signal that some routine costs incurred at the time of a corporate merger might be subject to capitalization. Rev. Ruling 99-23 and Letter Ruling 199901004 are helpful in trying to draw a line between start-up costs and costs incurred for an acquisition, which must be capitalized.