Corporation receives late safe-harbor election for acquisition success fees

Plain-English summary

A corporation paid success-based fees for two acquisitions and deducted the entire amount after relying on two accounting firms. A later auditor determined that the fees should have been substantiated under the capitalization regulations or handled through the safe harbor in Revenue Procedure 2011-29. The corporation requested permission to make the safe-harbor election after the original return deadline. The IRS found reasonable reliance on tax professionals and no prejudice to the government because the corporation reported net operating losses that exceeded the fees, including in later years. It granted relief even though the election year had closed, allowing the corporation to amend its treatment so that 70 percent of qualifying fees could be deducted and the remainder capitalized.

Ruling snapshot

• Question: May the corporation make a late Revenue Procedure 2011-29 election for success-based acquisition fees?
• Outcome: Approved.
• Key authorities: IRC §§ 263(a), 368, 446, 481(a); Treas. Reg. §§ 1.263(a)-5, 301.9100-1, 301.9100-3; Rev. Proc. 2011-29.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201622002 Third Party Communication: None
Release Date: 5/27/2016 Date of Communication: Not Applicable
Index Number: 9100.00-00
Person To Contact:
----------------------- ------------------------------,
---------------------------- ID No. ----------------
-------------------------------------------- Telephone Number:
---------------------- --------------------
-------------------------------- Refer Reply To:
CC:ITA:B02
PLR-110366-15
Date:
February 24, 2016

TY: ------

LEGEND:

Taxpayer = ----------------------------------------------------------------------
Acquisition Assistant = ------------------------------------
Country1 = ------------------
Country2 = ----------
Corp1 = ------------------------------
Corp2 = -------------------------------
CPA1 = ---------------------------------------
CPA2 = ----------------------------------
CPA3 = ----------------------------------------
Date1 = -------------------
Date2 = -------------
Date3 = -------------
Date4 = --------------------------
Date5 = ------------------
Date6 = ---------------------------
Year1= ------
Year2 = ------
Year3 ------
Taxable Year = ------
$a = ---------- --------------
$b = ---------- --------------
$c = ---------- --------------

Dear ------------:
PLR-110366-15 2

This is in response to your letter dated Date1. Taxpayer requests an extension of time
be granted for the purpose of allowing Taxpayer to select the safe harbor treatment
under Rev. Proc. 2011-29, 2011-18 I.R.B. 746, by amending Taxpayer’s original
Taxable Year return, and including the mandatory statement regarding the election to
use the safe harbor method of allocating success-based fees. This request is made in
accordance with §§ 301.9100-1 and 301.9100-3 of the Procedure and Administration
Regulations.

Taxpayer represents the following facts:

Taxpayer is a C-corporation and parent of a Country1 consolidated return group.
Taxpayer is engaged in the exploration, exploitation, acquisition, development and
production of crude oil, natural gas and natural gas liquids in numerous states.

The Transactions:

On Date2, Taxpayer acquired Corp1, a publicly traded exploration and production
company in a stock-for-stock exchange. This transaction was intended to qualify as a
reorganization under § 368(a)(1)(c) of the Internal Revenue Code.

On Date3, Taxpayer acquired Corp2 (including its wholly-owned Country1 subsidiary), a
publicly traded Country2 oil and gas company, in a stock-for-stock exchange.

To assist Taxpayer in the two acquisition transactions, Taxpayer engaged Acquisition
Assistant to act as financial advisor to Taxpayer. The fee for the Assistant’s services for
both Corp1 and Corp2’s acquisition was equal to1.20% and 1.00%, respectively, of the
fair value of consideration paid for each acquisition (but, in no event less, than $a) plus
reimbursement of our-of-pocket expenses. These fees were payable to Acquisition
Assistant on consummation of each acquisition. Therefore when Taxpayer closed on
Corp1 on Date2, and Corp2 on Date3, Taxpayer paid the Acquisition Assistant $b and
$c, respectively.

Circumstances of Late Election:

Taxpayer did not have an internal tax department or a tax director. Accordingly,
Taxpayer engaged CPA1 to assist in the preparation and filing of its federal income tax
return for the Taxable Year.

CPA1 reported the acquisition fees consistent with Taxpayer’s method of accounting
adopted for financial statement purposes, and treated these fees as a deductible
expense. CPA1 did not consider the requirements or documentation as set forth under
§ 1.263(a)-5(f) of the Income Tax Regulations to establish that a portion of either fee
paid to the Acquisition Assistant was allocable to activities that did not facilitate either
transaction, nor did CPA1 mention a safe harbor election under Rev. Proc. 2011-29.
PLR-110366-15 3

Relying on CPA1’s expertise, Taxpayer deducted the entire amount it paid to its
Acquisition Assistant for the taxable year ended Date4.

Taxpayer then engaged CPA2 to provide an independent examination of Taxpayer’s
financial statements from Year1 through the second quarter of Year2. During that
period CPA2 provided an unqualified opinion including assertions that no material
weaknesses existed for failing to disclose uncertain tax positions (including, for
example, uncertainty associated with treating the acquisition fees as a deductible
expense without satisfying the documentation requirements under the § 1.263(a)-5(f) of
the regulations. Both CPA1 and CPA2 believed the deduction treatment to have been
correct. Taxpayer relied on their expertise unaware of both CPAs’ incompetence and
oversight.

At the end of Year2, Taxpayer hired a new firm, CPA3, as an independent auditor.
During part of its initial audit, CPA3 found and immediately informed Taxpayer of the
improper tax treatment of the acquisition fees paid to the Acquisition Assistant.
Taxpayer had deducted all the fees as instructed by CPA1 and reassured by CPA2.
CPA3 explained to Taxpayer that the acquisition fees should have only been partially
deducted under the substantiation requirements of §1.263(a)-5(f) of the regulations or in
lieu of this requirement, Taxpayer’s former CPAs should have advised Taxpayer to use
the safe-harbor election available under Rev. Proc. 2011-29. The oversight was not yet
uncovered by the Internal Revenue Service. Therefore, CPA3 advised Taxpayer to file
a letter ruling requesting additional time to amend Taxpayer’s original federal income
tax return for Taxable Year.

Although advised by CPA3 to file for a letter ruling in late Year2, extenuating
circumstances precluded Taxpayer from requesting relief to elect the safe harbor as
proper treatment until Year3. The late filing was due to Taxpayer’s internal changes
such as creating a tax department and hiring a new Tax Director, and external changes
of tax advisors. This created competing priorities and limited resources to rectify a
number of material weaknesses including the tax treatments of the fees.

Finally, we note that when this letter ruling was filed with the Service on Date1, the
Taxable Year at issue was open. However, during the processing of the request, the
Taxpayer’s Taxable Year closed on Date6.

LAW:

Section 263(a)(1) and § 1.263(a)-2(a) provide that no deduction shall be allowed for any
amount paid out for property having a useful life substantially beyond the taxable year.
In the case of an acquisition or reorganization of a business entity, costs that are
incurred in the process of acquisition and that produce significant long-term benefits
must be capitalized. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 89-90 (1992);
Woodward v. Commissioner, 397 U.S. 572, 575-576 (1970).
PLR-110366-15 4

Under § 1.263(a)-5 of the regulations, a taxpayer must capitalize an amount paid to
facilitate a business acquisition or reorganization transaction described in § 1.263(a)-
5(a). An amount is paid to facilitate a transaction described in § 1.263(a)-5(a) if the
amount is paid in the process of investigating or otherwise pursuing the transaction.

Section 1.263(a)-5(f) provides that an amount that is contingent on the successful
closing of a transaction described in § 1.263(a)-5(a) (“success-based fee”) is presumed
to facilitate the transaction, and thus must be capitalized. A taxpayer may rebut the
presumption by maintaining sufficient documentation to establish that a portion of the
fee is allocable to activities that do not facilitate the transaction, and thus may be
deductible.

A taxpayer’s method for determining the portion of a success-based fee that facilitates a
transaction and the portion that does not facilitate the transaction is a method of
accounting under § 446.

Because the treatment of success-based fees was a continuing subject of controversy
between taxpayers and the Service, the Service published Rev. Proc. 2011-29. Rev.
Proc. 2011-29 provides a safe harbor method of accounting for allocating success-
based fees paid in business acquisitions or reorganizations described in regulations
§ 1.263(a)-5(e)(3). In lieu of maintaining the documentation required by § 1.263(a)-5(f),
this safe harbor permits electing taxpayers to treat 70 percent of the success-based fee
as an amount that does not facilitate the transaction that is, amounts that can be
deducted. The remaining portion of the fee must be capitalized as an amount that
facilitates the transaction.

Section 4.01 of Rev. Proc. 2011-29 allows the taxpayer to make a safe harbor election
with respect to success-based fees. Section 4.01 provides that the Service will not
challenge the taxpayer’s allocation of success-based fees between activities that
facilitate a transaction described in § 1.263(a)-5(e)(3) (cost that must be capitalized)
and activities that do not facilitate the transaction (cost that may be deductible) if the
taxpayer does three things. First, the taxpayer must treat 70 percent of the amount of
the success-based fee as an amount that does not facilitate the transaction and thus
may be deductible. Second, the taxpayer must capitalize the remaining amount of the
success-based fee as an amount which does facilitate the transaction. Finally, the
taxpayer must attach a statement to its original federal income tax return for the taxable
year the success-based fee is paid or incurred, stating that the taxpayer is electing the
safe harbor, identifying the transaction, and stating the success-based fee amounts that
are deducted (treated as not facilitating the transaction) and capitalized (treated as
facilitating the transaction).

Section 301.9100-1(c) provides that the Commissioner has discretion to grant a
reasonable extension of time under the rules set forth in §§ 301.9100-2 and 301.9100-3
PLR-110366-15 5

to make certain regulatory elections. Section 301.9100-1(b) defines a “regulatory
election” as an election whose due date is prescribed by a regulation published in the
Federal Register, or a revenue ruling, revenue procedure, notice or announcement
published in the Internal Revenue Bulletin.

Sections 301.9100-1 through 301.9100-3 provide the standards the Commissioner will
use to determine whether to grant an extension of time to make an election. Section
301.9100-2 provides automatic extensions of time for making certain elections. Section
301.9100-3 provides extensions of time for making elections that do not meet the
requirements of § 301.9100-2.

Section 301.9100-3(a) provides that requests for relief under § 301.9100-3 will be
granted when the taxpayer provides evidence to establish to the satisfaction of the
Commissioner that the taxpayer acted reasonably and in good faith, and that granting
relief will not prejudice the interests of the government.

In the instant case, Taxpayer did not have an internal tax department or expertise to
determine the proper treatment of the Acquisition Assistant’s fee following the
reorganization and stock acquisition transactions in Taxable Year. Thus, Taxpayer
hired tax experts to properly advise him and correctly file the Taxable Year return.
CPA1 advised Taxpayer to deduct the entire cost of the acquisition fee. Taxpayer relied
on CPA1’s expertise and followed his instructions. Then Taxpayer hired CPA2 to
double check his reliance on CPA1. CPA2 found no error in CPA1’s advice to
Taxpayer. The improper tax treatment was discovered by CPA3 in Year2. CPA3
informed Taxpayer of the improper treatment of the acquisition fees and, in turn, the
safe harbor under Rev. Proc. 2011-29. Taxpayer made a good faith effort to file his
taxes correctly by hiring several CPAs. CPA1 and CPA2, however, failed to properly
advise Taxpayer. Only CPA3 was familiar with the law including whether to elect the
safe harbor treatment under Rev. Proc. 2011-29, and informed Taxpayer to file a ruling
request for relief. Taxpayer acted in good faith and reasonably relied on the tax
professionals, but his reliance on the first two CPAs was detrimental.

Section 301.9100-3(c)(1) provides that the interests of the government are prejudiced if
granting relief would result in the taxpayer having a lower tax liability in the aggregate
for all taxable years affected by the election than the taxpayer would have had if the
election had been timely made. The interests of the government are ordinarily
prejudiced if the taxable year in which the regulatory election should have been made,
or any taxable years that would have been affected by the election had it been timely
made are closed by the period of limitations on assessment.

In Taxpayer’s case, granting relief will not result in Taxpayer having a lower tax liability
in the aggregate for all taxable years affected by the safe harbor election than it would
have had if this election had been timely made. Taxpayer filed its federal tax return on
Date5 for tax year ended Taxable Year. Moreover, Taxpayer reported a net operating
PLR-110366-15 6

loss that exceeded the amount of the deduction for the transaction fees, and for each
tax year succeeding tax year ended in Taxable Year, Taxpayer reported a net operating
loss. Thus, the interests of the government will not be prejudiced by granting the
request for relief.

CONCLUSION:

Based upon our analysis of the facts as represented, Taxpayers acted reasonably and
in good faith, and granting relief will not prejudice the interests of the government, and
therefore the requirements of §§ 301.9100-1 and 301.9100-3 have been met.

Furthermore, granting relief will not result in Taxpayer having a lower tax liability in the
aggregate for all taxable years affected by the election than Taxpayer would have had if
the election had been timely made, nor is Taxpayer seeking to alter a return position or
using hindsight. Taxpayer is not seeking to alter a return position or using hindsight as
the relief requested benefits the Service and not Taxpayer as it requires an unfavorable
adjustment to Taxpayer’s net operating loss (NOL). Therefore, the interests of the
government will not be prejudiced by granting the request for relief.

Moreover, now that Taxable Year is a closed year, we believe the interests of the
government are not prejudiced as the request results in an adjustment to Taxpayer’s
NOL carry forward and such adjustment would be in an open year.

Finally, granting relief will not prejudice the interests of the government associated with
the special rules for accounting method regulatory elections, in this case the safe harbor
election for success-based fees. The election provided by Rev. Proc. 2011-29 for
allocating the success-based fees is granted on an automatic basis (if all proper
procedures including the attaching the mandatory statement are followed), does not
require a § 481(a) adjustment, is not an issue under consideration, and does not
provide a more favorable method of accounting if the election is made by a certain date
or taxable year.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter. In particular, no opinion is expressed as to whether Taxpayer properly
included the correct costs as its success-based fees subject to the retroactive election,
or whether Taxpayer’s transactions were within the scope of Rev. Proc. 2011-29.
This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, a taxpayer filing its return electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.
PLR-110366-15 7

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

                                   Sincerely,



                                   _____________________________
                                   THOMAS D. MOFFITT
                                   Chief, Branch 2
                                   Associate Chief Counsel
                                   (Income Tax & Accounting)

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