Proposed IRS Regulations Clarify Allocation of M&A Costs
The IRS has proposed regulations that are intended to eliminate any perceived electivity involving “the next day rule” when allocating certain transaction costs between a pre-closing tax period and a post-closing tax period of a target corporation in certain acquisition transactions.
The Current Rules
If a target corporation (“target”) becomes or ceases to be a member of a consolidated group then the current regulations provide an end of the day rule in which target’s tax year for federal income tax purposes will end at the end of the closing date. Any items accrued on the closing date will be allocated to target’s tax year that ends on the closing date. As a result of the acquisition, target generally will incur significant costs, including success-based banker fees and compensation payments, and pursuant to the end of the day rule, the deductions associated with those costs would be allocated to the taxable period ending on the closing date.
The next day rule is an exception to the end of the day rule and generally provides that if a transaction occurs on the closing date that is properly allocable to the portion of the day after the closing, then the parties must treat that transaction as occurring at the beginning of the next day. This rule came about because of the concern that a buyer may cause target to enter into a transaction on the closing day after it became the legal owner and the tax consequences of such transaction would be allocated to the seller’s consolidated group’s pre-closing tax return. For example, if on the closing date but after the closing the buyer causes target to sell certain assets at a gain, that gain would be included in the selling group’s consolidated income tax return.
To determine whether a transaction is properly allocable to the next day, the current regulations provide that the allocation will be respected if it is reasonable and consistently applied by the parties. The IRS was concerned, however, that taxpayers perceived that the allocation of target transaction costs was elective and that some taxpayers have been manipulating the rules in order to achieve tax results that were not intended. For instance some parties to an agreement may have interpreted the current regulations to allow them to agree to deduct target’s success based banker fees in target’s post-closing tax year since the payment is made post-closing. The proposed regulations make clear that this type of allocation is not elective.
The Proposed Rules
The proposed regulations generally clarify the period in which target must report certain tax items and replace the current next day rule with a new next day rule. The new next day rule generally provides that “extraordinary items” resulting from transactions that occur on the closing day, but after the closing, are to be allocated to target’s tax return beginning the next day. The new next day rule does not apply to extraordinary items that arise simultaneously with the target acquisition. The current regulations already define extraordinary items, which include compensation-related deductions, such as deductions from bonuses, severance and option cancellation payments, and the proposed regulations clarify that compensation-related deductions also include a deduction for fees for services, such as investment banker success fees.
The proposed regulations make it clear that to the extent target incurs any of these compensation-related deductions that become fixed and determinable at closing. they have to appear on target’s pre-closing tax return. The buyer and seller will no longer be able to agree that these deductions, or any other extraordinary items that occur as a result of the target acquisition, can be allocated to a post-closing year.
Even though the proposed regulations are to apply to consolidated return years beginning on or after the date the proposed regulations are published as final regulations, parties to an acquisition agreement should take these proposals into consideration when determining what period certain deductions fall into.