INDOPCO and the tax treatment of reorganization costs.

• Author: Silverman, Mark J.

Overview

Section 162(a) of the Internal Revenue Code allows a deduction for all "ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business...." Section 263, however, prohibits deductions for amounts "paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate." Such items must be capitalized.

The line between what items may be deducted and what items must be capitalized has long been a question for debate in the tax field.(1)(*) In INDOPCO, Inc. v. Commissioner,(2) the Supreme Court held that expenditures incurred by a target corporation in the course of a friendly takeover are nondeductible capital expenditures. Although INDOPCO clarified the law as it pertains to target corporations in successful friendly takeovers, issues remain regarding the deductibility of expenses related to failed or abandoned transactions, expenses related to fighting hostile takeovers, expenses related to searching for white knights, expenses related to divisive reorganizations, expenses related to proxy fights, and costs of obtaining financing to redeem shares to prevent a hostile takeover, among others. This article addresses those issues. (The authorities discussed in this article are summarized in Exhibit 1--see page 39.)

Costs for Uncontested Acquisitions

1. Costs Incurred by Target Corporations: National Starch and INDOPCO

   1. Early Revenue Rulings. In Rev. Rul. 67-125,(3) the Internal Revenue Service held that legal fees for advice on the tax significance of a potential reorganization must be capitalized. The IRS ruled first that legal fees incurred for services performed in drafting a merger agreement must clearly be capitalized as incident to a reorganization, since the merger changes the capital structure of the corporation. The IRS went on to explain that legal fees for advice on the tax ramifications of such reorganization are "just as necessary in effecting a reorganization as those for the actual drafting of the reorganization agreement."(4)

      In Rev. Rul. 73-580,(5) the IRS held that compensation paid for services performed by employees relating to reorganizations should be treated the same as fees paid for similar services performed by outsiders. Thus, under the analysis set forth in Rev. Rul. 67-125, the portion of compensation paid to employees in connection with services relating to a reorganization must be capitalized.

   2. National Starch. In National Starch and Chemical Corp. v. Commissioner,(6) the Third Circuit, in affirming a Tax Court decision, held that a corporation must capitalize consulting fees, legal fees, and other expenses incurred in deciding whether to accept a friendly takeover bid. Unilever, the acquirer, was a U.S. company that was owned by a foreign company. Wanting to increase its U.S. revenues relative to its overall revenues, the foreign company directed Unilever to approach National Starch, one of Unilever's suppliers, to determine whether National Starch was interested in being the target of a friendly takeover. Unilever made it clear that it was only interested in a friendly takeover.

      To accommodate the principal shareholders of National Starch, the transaction was consummated in two steps. In step one, shareholders of National Starch were given the opportunity to exchange each share of National Starch common stock for one share of nonvoting preferred stock of a newly formed subsidiary of Unilever. This transaction was intended to be tax free under section 351.(7) In step two, a transitory subsidiary of the Unilever subsidiary was merged into National Starch, and any National Starch common stock not exchanged under step one was converted into cash (a "reverse subsidiary cash merger").

      National Starch hired independent investment bankers and attorneys to assist in valuations and to ensure that the board of directors did not breach any fiduciary duties. In addition, National Starch incurred miscellaneous fees such as accounting, printing, proxy solicitation, and SEC fees in connection with the transaction. National Starch deducted these fees, but upon audit the IRS concluded that they should be capitalized.

      National Starch argued that the Supreme Court's holding in Commissioner v. Lincoln Savings & loan Association(8) established a rule that an expense is a capital expense only if a separate and distinct additional asset is created or enhanced by the expense. Since there was no separate asset created under the merger, National Starch contended, the fees should not be capitalized. Thus, the corporation should be allowed to deduct the expenses under section 162(a). Furthermore, National Starch argued that Lincoln Savings specifically rejected looking to the presence of a future benefit to determine whether expenditures were ordinary and necessary.

      The Tax Court and Third Circuit in National Starch rejected with the taxpayer's arguments. The Third Circuit held that Lincoln Sauings did not establish a "separate and distinct asset" test and that an expense may be a capital expense, even though there is no separate and distinct asset. Although the court stated that no single factor controls the deduction/capitalization distinction, the Third Circuit seemed to adopt a "future benefits" test. Under this test, an expense must be capitalized if such expense produces benefits for the future.(9) Whether or not an expense will produce a future benefit is a question of fact.

   3. INDOPCO. The Supreme Court in INDOPCO affirmed the Third Circuit's decision in National Starch.(10) The Court held that the fees noted above "produced significant benefits to National Starch that extended beyond the tax year in question....(11) Thus, they must be capitalized. The Court held that the fees not creating or enhancing a separate and distinct additional asset under Lincoln Savings "is not controlling."(12) Lincoln Savings did not hold that only expenditures that create or enhance separate and distinct assets are to be capitalized, just that those that do must be capitalized. The Court in INDOPCO concluded that investment banker fees, legal fees, proxy costs, and SEC fees incurred by a target corporation in a friendly takeover must be capitalized if the takeover produces significant future benefits.(13)

      Regarding the future benefits test, the Court stated that "although the mere presence of an incidental future benefit...may not warrant capitalization, a taxpayer's realization of benefits beyond the year in which the expenditure is incurred is undeniably important" in determining whether the costs must be capitalized.(14) Thus, the Supreme Court did not literally establish a future benefits test. Rather, it provided only that such a benefit is "undeniably important" in determining whether an expenditure must be capitalized.(15) Subsequent cases, however, use future benefits as the touchstone in determining whether an expense may be deducted.(16)

   4. Payments to Employees Terminating Unexercised Stock Options. Corporations that are acquired in reorganizations often must make payments to employees holding unexercised stock options in order to facilitate the transaction. In Rev. Rul. 73-146,(17) the IRS held that payments to target employees to terminate unexercised stock options, as a condition of a reorganization, are compensation to the employees, and deductible by the corporation. The IRS ruled that the cancellation of the options was not in satisfaction of a new obligation generated by the reorganization, but in satisfaction of a pre-existing obligation of a compensatory nature. Thus, payment to employees was deductible as an ordinary and necessary business expense under section 162.(18)

      Another issue arises concerning amounts paid to employees to terminate unexercised stock options that are in excess of amounts that would have been paid to the employees had a pending takeover not influenced the stock price. In one technical advice memorandum (TAM),(19) the IRS addressed this issue in the context of both stock options and stock appreciation rights. The IRS held that such payments "are substantially the same as the payments that were analyzed by the IRS in Rev. Rul. 73-146."(20)

      Although the revenue agent had contended that the excess over the amount that would have been paid to employees barring the pending takeover should be capitalized, the IRS National Office concluded that the distinction is not controlling. The IRS explained that such a premium may have been present in Rev. Rul. 73-146. In addition, the premium was merely the fair market value of the stock at that time, and compensation to the employee would rise along with the fair market value. The IRS also said that a deductible expense is not converted to a capital expenditure solely because the expense is incurred as part of a reorganization.

      As opposed to these rulings, in Jim Walter Corp. v. United States,(21) the Fifth Circuit held that a corporation could not deduct an amount paid to repurchase warrants. The exercise of a warrant entitled the holder to one share of common stock and two 26.9-percent subordinated bonds. The corporation in Jim Walter wanted to repurchase the warrants because it was conducting a separate public offering of securities, and the underwriters feared that the warrants might be exercised, thereby causing the issuance of substantial debt obligations and shares of common stock, which in turn would generate large interest payments and a serious dilution of shareholder equity and earnings per share.

      The court in Jim Walter stated that the repurchase of warrants was a recapitalization expense associated with the public offering, and held that expenses incurred in connection with the acquisition or issuance of corporate stock are nondeductible capital expenditures. The court implied that it might reach a different result if the repurchase of the warrants had been necessary for the corporation's survival. Although the...