CCA 1036009: Assumed bankruptcy liabilities may require capitalization

Plain-English summary

Chief Counsel advised that assuming liabilities in connection with a bankruptcy asset purchase under sections 363 and 365 of the Bankruptcy Code does not, by itself, prevent capitalization under IRC § 263. The analysis treated the assumed liabilities as potential components of the purchaser's cost because the purchaser selected and expressly assumed them as part of an arm's-length transaction for the assets. It rejected a categorical rule based on the bankruptcy court's valuation of the assets, the amount of cash paid, or the purchaser's ability to avoid liabilities before closing. The memorandum also explained that fixed liabilities assumed in the transaction did not require the same analysis as contingent liabilities, and that individual liabilities might require a separate review. The taxpayer withdrew its requested ruling after receiving an adverse preliminary conclusion.

Ruling snapshot

• Question: Does a bankruptcy asset acquisition under sections 363 and 365 prevent capitalization of assumed liabilities under IRC § 263?
• Outcome: Advice given
• Key authorities: IRC §§ 263, 263A, 404, 461, 1001, 1012, and 1060; Bankruptcy Code §§ 363 and 365

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       Memorandum
       Number: 201036009
       Release Date: 9/10/2010
       CC:ITA:B02:RMKelley                           Third Party Communication: None
       PLR-152190-09                                 Date of Communication: Not Applicable

UILC: 263.00-00

date: May 25, 2010

 to:   Internal Revenue Service
       Industry Director, Heavy Manufacturing and Transportation
       (Large & Mid-Size Business)

       Internal Revenue Service
       Director of Pre-Filing Technical Guidance
       (Large & Mid-Size Business)

from: John P. Moriarty
Chief, Branch 1
(Income Tax & Accounting)

subject: Withdrawal of letter ruling request

       In accordance with section 7.07(2)(a) of Rev. Proc. 2010-1, 2010-1 I.R.B. 1, 29, we are
       advising you that a taxpayer within your operating division’s jurisdiction has withdrawn a
       request for a letter ruling after this office advised the taxpayer of its conclusion adverse
       to the taxpayer’s requested ruling. Following is a brief discussion of the issue, facts,
       applicable law, and the reasons for this office’s conclusion. This memorandum may not be
       used or cited as precedent.


       LEGEND

       Taxpayer             =      ---------------------------------------------------------------------------------
       Seller               =      ----------------------------------------------------------------
       Owner                =      --------------
       Parties              =      ----------
       x                    =      -------------------
       Date 1               =      ------------------
       Date 2               =      ------------------

Date 3 = -----------------
Date 4 = -------------------
Date 5 = -------------------
Date 6 = -----------------------

ISSUE

Does the fact that the liabilities assumed by Taxpayer were assumed in connection with
the acquisition of assets in a transaction described in sections 363 and 365 of the
Bankruptcy Code preclude capitalization under § 263 of the Internal Revenue Code?

CONCLUSION

The fact that the liabilities at issue were assumed in connection with the acquisition of
assets in a transaction described in sections 363 and 365 of the Bankruptcy Code does
not per se preclude capitalization under § 263.

FACTS

On Date 1, Seller filed bankruptcy petitions seeking relief under Chapter 11 of the
United States Bankruptcy Code. On Date 2, Taxpayer and other interested parties filed
with the bankruptcy court an asset purchase agreement (the Agreement), detailing the
proposed sale of substantially all of Seller’s assets to Taxpayer. The asset acquisition
allowed Taxpayer to acquire tangible and intangible assets from Seller, including
contracts to which Seller was a party. The Agreement also contained other provisions
pertaining to the transfer of Seller’s business to Taxpayer, including the terms under
which Seller’s employees would be offered employment by Taxpayer.

Taxpayer’s ruling request pertained to liabilities that Taxpayer assumed under the terms
of the Agreement. The Agreement states that Taxpayer assumed certain liabilities of
Seller (the Assumed Liabilities) and paid cash consideration of $x to Seller in exchange
for the assets. The Agreement further provides that the aggregate consideration
provided by Taxpayer to Seller for the assets included both the assumption of the
Assumed Liabilities and the cash consideration. Seller’s financial advisor determined
that the assumption of liabilities would benefit Seller and that the cash consideration
combined with the assumption of the Assumed Liabilities was fair consideration for the
assets from Seller’s point of view. ----------------------------------------------------------------------

The asset sale was approved by the bankruptcy court in an order dated Date 3, and the
transaction closed on Date 4. The Agreement was amended in a series of amendments
dated on or before Date 5 and a final amendment dated Date 6.

In the court’s order authorizing the sale, the court found that the Agreement represented
an arms-length transaction between the parties. In reaching this conclusion, the court
stated---:

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In the court’s opinion granting Seller the authority to sell the assets, the court approved
the terms of the Agreement, specifically noting the consideration recited in the
Agreement consisting of the cash payment and the assumption of the Assumed
Liabilities. ------------------------------------------------------------------------------------------------------

------------------------------------------------------------------------ The court recognized that the
amount of cash consideration reflected the liabilities that Taxpayer chose to assume in
connection with assumed contracts. The court stated----:

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The court concluded that the secured creditors could not have recovered $x in a
piecemeal liquidation of Seller’s assets. In support of this position, the court indicated
that:

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Finally, the court concluded that Taxpayer’s assumption of unsecured liabilities as part
of the transaction did not violate bankruptcy law. In reaching this conclusion, the court
reasoned as follows:

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In its ruling request, Taxpayer placed the Assumed Liabilities into three broad
categories: (1) executory contract liabilities; (2) commercial interest liabilities; and (3)
liabilities secured by liens against certain of the acquired assets that were not
discharged in the bankruptcy. Taxpayer requested a ruling on liabilities described in
categories (1) and (2). In response to notification that this office was tentatively adverse
to Taxpayer’s requested ruling, Taxpayer proposed further limiting the ruling request to
nine broad categories of liabilities. These categories were: (1) ---------------------------------

------------------(2) ----------------------------------------------------------------------------------------------

(3) ----------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------(4) workers’
compensation liabilities under claims relating to pre-acquisition incidents; (5) active
healthcare liabilities for unbilled medical services that were provided to employees
before the acquisition; (6) post-retirement medical costs for certain former employees
of Seller; (7) supplemental deferred pay liabilities related to certain employee life
insurance plans; (8) restructuring reserves liabilities for future costs of certain
restructuring activities which either had commenced or had been in planning stages
before the acquisition; and (9) assumed contract liabilities. The final category, assumed
contract liabilities, generally includes liabilities under all written contracts, leases,
licenses, arrangements, notes, bonds, mortgages, indentures, franchise agreements,
insurance agreements and arrangements, instruments, commitments, undertakings and
other agreements and binding obligations to which Taxpayer, Seller or Owner is a party.
These nine broad categories of Assumed Liabilities are composed of numerous
separate liabilities. The Assumed Liabilities include both fixed and contingent liabilities.

LAW AND ANALYSIS

The underlying legal issue in this case is whether Taxpayer’s assumption of liabilities
must be capitalized to the basis of the acquired assets under § 263(a).1 Section 263(a)
disallows deductions for capital expenditures. A capital expenditure is an amount paid
“for new buildings or for permanent improvements or betterments made to increase the
value of any property or estate.” Section 263(a). The regulations explain that capital
expenditures include any “cost of acquisition, construction, or erection of buildings,
machinery and equipment, furniture and fixtures, and similar property having a useful
life substantially beyond the taxable year.” Section 1.263(a)-2(a) of the Income Tax
Regulations.

A buyer who purchases business assets and assumes a seller's liabilities, fixed or
contingent, in connection with the acquisition must capitalize payments made on such
liabilities. See, e.g., David R. Webb Company, Inc. v. Commissioner, 708 F.2d 1254
(7th Cir. 1983); Pacific Transport Company v. Commissioner, 483 F.2d 209 (9th Cir.
1973), cert. denied, 415 U.S. 948 (1974); Portland Gasoline Company v. Commissioner,
181 F.2d 538 (5th Cir. 1950). A buyer's payment of the liabilities is not the discharge of
a burden the law placed on the buyer; it is actually as well as theoretically a part of the
purchase price. Magruder v. Supplee, 316 U.S. 394, 398 (1942). As a factual matter,
however, it is sometimes difficult to distinguish between contingent liabilities assumed
from the seller and expenses the buyer incurs while operating the ongoing acquired
business.

Case law identifies a number of factors to be considered in determining whether
contingent liabilities must be capitalized. Illinois Tool Works v. Commissioner, 117 T.C.
39, aff'd, 355 F.3d 997 (7th Cir. 2004); David R. Webb Co., supra; Pacific Transport Co.,
supra; United States v. Smith, 418 F.2d 589 (5th Cir. 1969); Albany Car Wheel Co.,
supra; United States v. Minneapolis & St. Louis Ry., 260 F.2d 663 (8th Cir. 1958); M.
Buten & Sons, Inc. v. Commissioner, T.C. Memo 1972-44. These factors include:

    1) Whether the liability related to the seller’s or the purchaser’s operation of the
    business;
    2) Whether the liability arose out of pre- or post-acquisition events;
    3) Whether the purchaser was aware of the liability;
    4) Whether the liability was contemplated when negotiating the purchase price;
    5) Whether the purchaser expressly assumed the liability; and
    6) Whether the purchaser could have avoided the liability.

In short, capitalization is required where the events most crucial to creation of the
obligation occur before the acquisition, while deduction is allowed where the events
most crucial to creation of the obligation occur after the acquisition. United States v.

1
The transaction implicates numerous other issues, including whether the payments are ordinary
and necessary business expenses that are deductible under § 162; whether Taxpayer must capitalize the
purchase of intangible assets, such as contract rights and/or goodwill; to what extent the payments must
be capitalized to the cost of produced assets under § 263A; the timing of deductions or capitalization
under § 461; and the timing of deferred compensation deductions under § 404. These issues were
beyond the scope of Taxpayer’s ruling request.

Minneapolis & St. Louis Ry., supra; Albany Car Wheel Co., supra; M. Buten & Sons,
Inc., supra.

In support of its requested ruling, Taxpayer advanced several theories, which we group
here into two main arguments. First, Taxpayer argued that the unique facts of its case
showed that the assumption of liabilities was not, and legally could not have been, part
of the purchase price that Taxpayer paid for the assets. In effect, Taxpayer reasoned
that the fact that the liabilities assumed by it were assumed in connection with the
acquisition of assets in a transaction described in sections 363 and 365 of the
Bankruptcy Code precludes capitalization under § 263, both because the liabilities were
economically worthless in the hands of Seller and because the liabilities could have
been avoided by Taxpayer and ultimately discharged by the bankruptcy court. Second,
Taxpayer argued that because of these unique facts, an analysis of the traditional
factors outlined above demonstrates that the Assumed Liabilities were not part of the
purchase price of the assets. Thus, under these arguments, Taxpayer would not be
required to capitalize any of the assumed liabilities to the purchase price of the assets
(“bright line arguments”). For the reasons discussed below, we did not find Taxpayer’s
arguments to be persuasive.

Bankruptcy-focused bright line arguments

In support of its first argument, Taxpayer asserted that the bankruptcy court determined
that Taxpayer purchased the assets for $x, that the assumed liabilities were not part of
the purchase price, and that the secured creditors received the full purchase price for
the assets. Taxpayer’s arguments largely relied on the court’s statement that
Taxpayer’s assets were valued at less than $x. However, in making this statement the
court was not calculating Taxpayer’s purchase price for the assets. Instead, the court
was concluding that Seller could not have received more than $x in a piecemeal
liquidation of the secured assets. The Agreement approved by the court provided that
Taxpayer purchased the assets in exchange for consideration in the form of a cash
payment and the assumption of the Assumed Liabilities. In approving the Agreement,
the court found that it was an arms-length transaction, specifically noting that the
amount that Taxpayer was willing to pay was affected by which contracts Taxpayer
chose to assume, the assumption of which also required Taxpayer to assume the
liabilities to make cure payments. ------------------------------------------ Similarly, the court’s
conclusion that the secured creditors received fair value for the secured assets was
merely a conclusion that the secured creditors would not have received more in a
liquidation. It was not a conclusion that an arms-length purchaser would have been
unwilling to assume a large number of liabilities, in addition to paying cash of $x, in
order to acquire substantially all of Seller’s assets and assume a large number of
Seller’s contracts in order to use those assets and contractual relationships to operate
its trade or business. In short, the issue before the bankruptcy court was not
Taxpayer’s cost of acquiring the assets; the issue was whether the secured creditors
could have received more than $x in a piecemeal liquidation of the secured assets and
whether any cash proceeds from the asset sale flowed to any party other than the

secured creditors. --- The bankruptcy court was not concerned with the amount of
consideration Taxpayer paid for the assets for purposes of Federal tax law.

Taxpayer next argued that Taxpayer could not have paid more for the assets than what
Seller (or the secured creditors) received; namely, the amount of cash consideration. At
the core of this argument was a purported distinction between the purchase price for the
assets and the total costs incurred in acquiring the assets. In other words, Taxpayer
argued that any amounts in excess of what Seller received could be characterized as
costs related to the acquisition of the assets, but could not be characterized as the
purchase price for the assets. Taxpayer did not provide any precedent for drawing this
distinction between purchase price and other costs in capitalizing expenditures incurred
in acquiring an asset. Federal tax law consistently looks to a seller’s amount realized as
the starting point for calculating gain or loss, and it looks to a purchaser’s cost as the
starting point for calculating basis. See §§ 1001(a) and 1012(a). Absolute symmetry
between amount realized and cost is not required. For example, § 1060 addresses the
allocation of the amount of consideration received by the seller of assets for purposes of
determining the purchaser’s basis in the assets and the seller’s gain or loss on the sale.
The regulations define consideration differently for the seller and the purchaser—
amount realized for the seller, cost for the purchaser—making it clear that the amount of
consideration may be different for each party. Section 1.1060-1(c)(1). Therefore,
distinguishing the cash consideration that Taxpayer paid from the liabilities that
Taxpayer assumed, by characterizing the cash as purchase price and the liabilities as
other costs of the acquisition, does not alter the result under § 263. Because the
amount that Taxpayer is required to capitalize under § 263 is not dependent on the
amount that Seller received from Taxpayer, we did not agree with Taxpayer that
capitalization is precluded if, as Taxpayer argued, Seller received no benefit from
Taxpayer’s assumption of the liabilities because the liabilities were economically
worthless and ultimately would have been discharged in the bankruptcy proceeding.

As final support for its first argument, Taxpayer argued that characterizing the
assumption of liabilities as part of the purchase price of the assets violates bankruptcy
law because this characterization implies that the unsecured creditors received a
portion of the purchase price, thereby bypassing the secured creditors. In support of
this argument, Taxpayer cited Commissioner v. First Security Bank of Utah, 405 U.S.
394 (1972), in which the Service sought to apply § 482 to recharacterize reinsurance
premiums paid to a related entity as insurance commissions paid to banks, at a time
when banks were prohibited under federal law from receiving insurance commissions
for acting as insurance agents. The Court held that this recharacterization was
improper because the banks never received shares of the premiums and never could
have received them because they were legally prohibited from doing so. The Court
noted that there was no finding in the case, and nothing in the record to support a
finding, that the banks had acted illegally. The Court gave “great weight” to the fact that
the banks had been regularly examined by federal banking authorities, who found no
violations of the law, as well as to the assumption by the government and the lower
courts that the activity was lawful. Id. at 402 n.16.

Taxpayer argued that First Security Bank of Utah supports the proposition that “courts
have generally not applied a tax result that was in conflict with prevailing law.” This
argument was not persuasive because, in reaching its decision, the Court in First
Security Bank of Utah noted that the form of the transaction and the legal prohibition
against receipt of commissions were consistent in reflecting the fact that the banks did
not and could not receive commissions. In the present case, the form of the
transaction, as reflected in the Agreement, was an assumption of liabilities in exchange
for assets, which is consistent with bankruptcy law that allows a purchaser of assets in a
§ 363 sale to assume unsecured liabilities in connection with the purchase. The
Agreement specifically stipulates that the Assumed Liabilities are part of the
consideration and, in approving the sale, the bankruptcy court specifically determined
that the assumption of unsecured liabilities in a § 363 sale does not violate the rights of
secured creditors. In particular, the court noted that a purchaser of assets may, for
business reasons, decide to assume unsecured liabilities of a seller, and that the
assumption of the liabilities does not violate bankruptcy law. -----------------------------------
------------ Indeed, in the present case, the secured creditors consented to the
transaction. ------------- In short, Taxpayer’s reliance on First Security Bank of Utah was
misplaced.

Because we did not find persuasive authority for Taxpayer’s bankruptcy-focused bright
line arguments that would allow Taxpayer to avoid capitalizing the assumed liabilities,
we turned to the traditional facts and circumstances analysis used in determining
whether contingent liabilities should be considered part of the purchase price of an
asset.

Facts and circumstances bright line argument

In support of its second argument, Taxpayer asserted that an analysis of the traditional
factors for determining when contingent liabilities are part of purchase price
demonstrates that the Assumed Liabilities were not part of the purchase price of the
assets in this case. In addressing this argument more specifically, Taxpayer proposed
further limiting the ruling request to the nine broad categories of liabilities discussed
above. For the reasons described below, we were unable to conclude that the
Assumed Liabilities are not subject to capitalization under § 263 when considered
collectively in the broad categories described by Taxpayer.

First, Taxpayer’s analysis of broad categories of liabilities did not account for fixed
liabilities that Taxpayer assumed as part of the transaction at issue. For many of the
Assumed Liabilities, the factors used in the traditional facts and circumstances analysis
are not relevant because they apply in determining when contingent liabilities should be
considered part of the purchase price of an asset. Many of the liabilities in this case
appeared to be Seller’s operating expenses incurred before the transaction that are not
contested or otherwise contingent, such as accounts payable to suppliers. That is,
many of the liabilities appear to be fixed. In these cases, there was no need to examine
the factors described above as, under the facts of this case, the liabilities existed and
were assumed as part of the acquisition. Furthermore, Taxpayer’s application of the
various factors developed under case law for considering contingent liabilities was not
persuasive. The various case law factors are addressed briefly below.

     Factors 1 and 2

The traditional facts and circumstances analysis first considers whether the liabilities
relate to the seller’s or the purchaser’s operation of the business and whether the
liabilities arose out of pre- or post-acquisition events. Taxpayer generally argued that
the liabilities related to the purchaser’s operation of the business because Taxpayer
elected to honor the liabilities in order to maintain strong customer relationships and
because Taxpayer could have purchased the assets free and clear of the liabilities
under § 363(f) of the Bankruptcy Code. We were not persuaded by this argument
because the information provided by Taxpayer showed that the Assumed Liabilities
related to Seller’s operation of the business. The liabilities existed at the time of the
asset acquisition and were incurred by Seller. The fact that Taxpayer was not legally
obligated to assume any of the liabilities in connection with the purchase of Seller’s
assets did not change the fact that the liabilities arose out of the pre-acquisition
business dealings of Seller. In other words, Taxpayer voluntarily chose to assume the
liabilities as part of the acquisition, but the voluntariness does not transform the
liabilities from pre-acquisition liabilities to post-acquisition liabilities.

     Factors 3 and 4

Taxpayer agreed that it was aware of the liabilities at the time of acquisition, so we next
considered whether the liabilities were contemplated when negotiating the purchase
price. Taxpayer argued that the assumed liabilities were not a factor in negotiating or
setting the purchase price of the acquired assets, and that the cash consideration was
the full purchase price, because the bankruptcy court concluded that the value of the
assets was less than $x. We did not agree with Taxpayer that the bankruptcy court’s
conclusion regarding the valuation of the assets implies that the valuation of the
liabilities was not a factor in the negotiations in this arms-length transaction. In fact,
court records show that Seller’s financial advisor took the valuation of the liabilities into
account in concluding that the transaction as a whole was fair from Seller’s viewpoint--.

Taxpayer also argued that two specific types of liabilities could not have been part of the
purchase price because they were assumed after the closing date; namely, the liabilities
assumed under contracts that were designated for assumption after the closing date,
and the liabilities assumed pursuant to the amendment to the Agreement dated Date 6.
Based on the limited information that Taxpayer provided, we were unable to conclude
that these liabilities should not be capitalized merely because details regarding their
incorporation into the Agreement were not completed until days or months after the

closing date.

    Factors 5 and 6

Because Taxpayer agreed that it expressly assumed the liabilities, the final factor to be
considered was whether the purchaser could have avoided the liability. Taxpayer
argued that it could have avoided the liabilities because bankruptcy law would have
permitted the sale of assets without the assumption of the liabilities. However, the
information provided by Taxpayer showed that Taxpayer agreed to assume the liabilities
in exchange for the assets in an arms-length transaction in which Taxpayer chose the
liabilities it wished to assume in light of the value of the assets it was acquiring. Once
the transaction was completed, Taxpayer could no longer avoid the liabilities. For
example, Taxpayer assumed liabilities under various supply contracts with respect to
which Taxpayer is required to pay cure amounts but which Taxpayer otherwise may
cancel at any time. While Taxpayer has the ability to avoid liabilities relating to future
supply orders (by opting not to order the supplies), once the asset acquisition was
completed Taxpayer could no longer avoid the liability to make the cure payments under
the contracts. The fact that Taxpayer was not legally required to assume the liabilities
for bankruptcy purposes is not relevant. Taxpayer voluntarily chose to assume the
Assumed Liabilities in exchange for the assets.

Conclusion

In conclusion, we were unable to provide Taxpayer’s requested ruling that the fact that
the liabilities at issue were assumed in connection with the acquisition of assets in a
transaction described in sections 363 and 365 of the Bankruptcy Code precludes
capitalization under § 263. Further, we were unable to conclude that, under the
traditional facts and circumstances analysis, the Assumed Liabilities are not subject to
capitalization under § 263 when considered collectively in the broad categories
described by Taxpayer. We note that considering the Assumed Liabilities in the broad
categories described by Taxpayer necessarily precluded a detailed analysis of specific
liabilities assumed by Taxpayer in the transaction. Such an analysis might have
resulted in the conclusion that particular liabilities need not be capitalized under § 263
as part of the acquisition of assets. For example, Taxpayer stated that the restructuring
reserves liabilities include liabilities for restructuring activities that were merely in the
planning stages before the acquisition. While we lacked sufficient factual information to
conclude categorically that Taxpayer is not required to capitalize any of these liabilities,
a detailed analysis of the facts and circumstances may have shown that all or a portion
of these liabilities are not required to be capitalized under § 263.

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