Government clarifies position on investigatory costs.

• Author: Tingey, Dennis
• Position: Pretransaction costs

Taxpayers often incur substantial "investigatory" costs before entering into a major transaction such as an acquisition or merger. Historically, taxpayers have looked to judicial authorities such as Briarcliff Candy. 475 F2d 775 (2d Cir. 1973) and NCNB, 684 F2d 285 (4th Cir. 1982), as well as the legislative history associated with the enactment of Sec. 195, for guidance as to when (or if) investigatory costs in an acquisition transaction may escape capitalization.

Taxpayers have been forced to reconsider their reliance on these authorities in the wake of INDOPCO, Inc., 503 US 79 (1992), causing them to question whether the broad capitalization doctrines suggested by the Supreme Court have in effect nullified much of the earlier guidance. Until recently, no specific guidance was available to help taxpayers assess the impact of INDOPCO on the characterization of investigatory costs incurred in connection with a major transaction.

Norwest

In March 1999, the Tax Court analyzed the treatment of investigatory costs in a business expansion context in the post-INDOPCO era. In Norwest, 112 TC 89 (1999), a local bank was approached about a possible merger with a large banking institution. Prior to any formal decision to enter into a merger agreement, the local bank spent $83,450 to (1) investigate the products, services and reputation of the acquiting bank, (2) ascertain whether the merger would be a viable business combination and (3) ascertain whether the proposed transaction would benefit the community.

The bank argued that these costs were deductible investigatory costs under Sec. 162, because they were incurred prior to a decision to enter into the transaction. The Tax Court acknowledged that the costs were incurred before and incidental to the subsequent acquisition. Nonetheless, it ruled that the costs were sufficiently related to the subsequent merger and should be capitalized as part of the overall transaction. The Tax Court stated it "read INDOPCO to have displaced the body of law set forth in Briarcliff Candy and its progeny insofar as they allowed deductibility of investigatory costs in a setting similar to that at hand."

The taxpayer appealed to the Eighth Circuit. Pending the decision on appeal, the Tax Court's decision appeared to require investigatory expenses to be capitalized--even if the costs are incurred prior to a decision to enter the transaction and related only distantly to the subsequent acquisition event.

Rev. Rul. 99-23

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