The National Starch Decision

With the proliferation of merger and acquisition activity, it was inevitable that the deductibility of expenditures incurred incident to these transactions would develop into a contested issue. The term "takeover expenses" can be broadly defined to include legal, investment banking, and other fees. The basis for the debate is summarized as follows: Are takeover expenses deductible, as ordinary and necessary business expenses pursuant to IRC Sec. 162(a), or should they be capitalized under Sec. 263(a) since they result in the long-term betterment of the corporation? A recent Tax Court decision, National Starch and Chemical Corp. v. Commissioner (93 T.C. No. 7, July 24, 1989), held that advisory fees incurred by a target corporation in a friendly acquisition must be capitalized. National Starch was preceded by TAM 8927005 (March 27, 1989), which concluded that expenses relating to a hostile takeover attempt were deductible. The subsequent revocation of this letter ruling in light of the National Starch decision has presented practitioners with additional wrinkles. This article briefly discusses TAM 8927005 and then examines the holding in National Starch.

TAM 8927005 (Subsequently

Revoked)

This letter ruling permitted a target company to deduct expenses incurred in resisting a hostile takeover attempt. The Board of Directors of the target believed that the takeover attempt by a highly leveraged real estate holding company was not in the best interests of the target or its shareholders. As a result, it engaged an outside advisor who, among other services, secured an alternative buyer and provided a fairness opinion. The initial suitor eventually agreed to cease its takeover efforts subsequent to the purchase of the target by the alternative buyer. To avoid a proxy fight, the target had agreed to reimburse the initial suitor for its out-of-pocket expenses relating to regulatory proceedings undertaken during the takeover attempt.

In detailing its reasoning for allowing the deductions, the IRS frequently cited the protection of shareholder interests as a paramount concern. The takeover expenses were deemed to have been made in fulfillment of the Directors' duty to act in the best interests of the company and to insure its continued profitability.

The expenses were also held to be ordinary and necessary in accordance with the judicial interpretation of these terms as discussed in Welch v. Helvering 290 U.S. 111 (1933). The reimbursed expenses were considered necessary in the case at hand since they were "appropriate and helpful" to the target and its shareholders in mitigating the potential harm which would have resulted if the initial suitor's tender offer had been consummated. The expenses were ordinary as well since they were made as the "common and accepted means of defense against attack."

National Starch

In this decision, the Tax Court held that certain takeover expenses incurred by the National Starch and Chemical Corporation relating to its successful, friendly takeover by Unilever United States, Inc., were not deductible pursuant to Sec. 162(a). Under this set of facts, National Starch was amenable to the proposed purchase, subject to provisions relating to the structure of the transaction and the tender price. Accordingly, an investment bank and a law firm were engaged to address these concerns. Counsel attempted to structure a taxfree transaction by forming two new companies so as to meet the demands of National Starch's largest shareholder. The investment bank valued the stock, rendered a fairness opinion, and stood ready to assist if there was a hostile tender offer. The fees and expenses incurred by National Starch related to the takeover (payable primarily to the investment bank and the law firm) ultimately totaled nearly $2.9 million.

Although the Court ruled in favor of the IRS, it rejected the IRS's three principal arguments for capitalizing the expenditures. The Court first dismissed the claim that the changes made to the National Starch Certificate of Incorporation were evidence of a recapitalization. Rather, these changes were found to have been made for administrative convenience and simplicity. In addition, the merger of one of the newly-formed companies into National Starch was deemed incidental to the transaction and did not cause the expenditures to be characterized as capital expenditures. Lastly, the transaction was not sufficiently similar to a reorganization under Sec. 368(a)(1)(B) so as to result in capitalization of the expenses.

Instead, Judge Clapp, writing for the Court, focused on claims made by the management of National Starch and its investment bankers that a union with Unilever would create synergies and provide National Starch with access to Unilever's enormous resources. For these and other reasons, the Directors of National Starch determined that it would be in their company's long-term interest to shift ownership of the corporate stock to Unilever. The fees and expenses were incurred in connection with the ownership shift; accordingly, this event resulted in a benefit "which could be expected to produce returns for many years in the future" E.I. duPont de Nemours and Co. v. U.S., 432 F.2d 1052, 1059 (3rd Cir. 1970). Any expenditure which results in such a benefit is properly capitalizable.

The court maintained this opinion in spite of its admitting that National Starch's business remained essentially unchanged after the acquisition, without "any significant technological or financial assistance" from Unilever. This lack of short-term benefits did not necessarily imply an absence of longterm benefits, however, primarily due to the length of time required to plan and implement changes in a corporation's operations.

National Starch had also contended that the Court, in determining the deductibility of the expenses, should look to the dominant aspect of the particular transaction. Accordingly, National Starch had deducted the expenses since it believed the dominant aspect of this transaction to be the fiduciary duty its directors owed to its shareholders. Instead, the Court found the transfer of National Starch stock to be the governing motive. As Judge Clapp descriptively stated: "We would let the tail wag the dog if we were to view the stock transfer as the incidental aspect (of the transaction) and the fiduciary duty that arose from the stock transfer as the dominant aspect."

Conclusion

Although the National Starch decision has been handed down and TAM 8927005 has been revoked, much steam is still being generated over the deductibility of takeover expenses. The following underlying issues still merit consideration:

* Is National Starch reconcilable with a number of precedents which precede these two pronouncements? For instance, the Supreme Court in Commissioner v. Lincoln Savings and Loan Association 403 U.S. 345 (1971), when assessing the deductibility of an expense, held that the presence of an ensuing benefit which may have some future aspect is not the controlling issue. Rather, the focus should be on whether the payment "serves to create or enhance a separate and distinct additional asset," in which case capitalization would be the proper treatment. Based on this rationale, it would appear difficult to argue that expenses similar to the type incurred by National Starch are being made to somehow enhance a particular asset.

* What are the ramifications for the fiduciary duty owed to shareholders by a Board of Directors? The Board's assessment of a potential change in ownership of a corporation should fall within the purview of its role in ensuring that the best interests of the shareholders are being served. Accordingly, it could be argued that the subsequent ordinary and necessary expenses relating to this assessment process should be deductible.

In any event, as long as merger and acquisition activity is pursued, the deductibility of takeover expenses will be debated and hopefully, eventually ironed out.