Merger approval conditions were not automatically facilitative costs

Plain-English summary

A regulated holding company incurred customer credits, community payments, charitable commitments, and other costs required as conditions for regulatory approval of a merger. The examining agent argued that the costs had to be capitalized because the company would not have incurred them without the merger and because obtaining regulatory approval is inherently facilitative. Chief Counsel rejected a categorical approach. The facilitative-cost rule is narrower than a simple but-for test, and it generally targets deal services such as legal, financial, investigatory, and administrative work. Costs that resemble recurring operating expenses or payments for intangible property are not automatically merger-facilitation costs merely because a regulator required them.

Ruling snapshot

• Question: Must every cost incurred to satisfy a regulator's conditions for merger approval be capitalized as a facilitative transaction cost?
• Outcome: advice given, the costs were not per se facilitative
• Key authorities: IRC §§ 162 and 263(a); Treas. Reg. §§ 1.263(a)-5(a), 1.263(a)-5(b), and 1.263(a)-5(e)

Full text (IRS public release)

           Office of Chief Counsel
           Internal Revenue Service
           Memorandum
           Number: 201713010
           Release Date: 3/31/2017
           CC:ITA:B01:ALWarren                            [Third Party Communication:
           POSTU-127013-15                                Date of Communication: <Month> DD, YYYY]

 UILC:     263.00-00

  date:    December 20, 2016

     to:   Danielle R. Dold
           Associate Area Counsel (LB&I), Chicago

  from:    Lewis K Brickates
           Chief, Branch 1
           Associate Chief Counsel
           (Income Tax & Accounting)


subject:   Tax Treatment of Costs Satisfying a Regulatory Authority Condition for Approval of
           Merger

           This Chief Counsel Advice responds to your request for assistance. This advice may
           not be used or cited as precedent.


           LEGEND


           Taxpayer        =   ---------------------------
           B               =   --------------------
           C               =   --------
           D               =   ------------------------------------------------------------------------------------------
                               --------------
           Company E       =   --------------------------------------------
           Subsidiary F    =   -------------------------------------
           G               =   ----------------
           Year 1          =   -------
           Company H       =   -------------------------------------
           City J          =   --------------------
           Regulatory      =   ---------------------------------------------------
           Board
POSTU-127013-15                                    2

Date 1          =   --------------------
Date 2          =   -------------------
Date 3          =   -----------------------
Date 4          =   --------------------------
State K         =   --------------
M               =   --------------
Amount N        =   -------
Amount O        =   -----------------
Year 2          =   -------
Amount P        =   ----------------
Date 5          =   -----------------
Amount Q        =   --------------------
Amount R        =   ----------------
S               =   -----------------------------
Amount T        =   --------------
U               =   ------------
Date 6          =   ----------------------
V               =   -----------------------------------------------------------------------


ISSUE

Section 1.263(a)-5(a) of the Income Tax Regulations (regulations) requires a taxpayer
to capitalize an amount paid to facilitate a transaction if the amount is paid in the
process of investigating or otherwise pursuing the transaction. Where a regulatory
agency approves a merger subject to certain conditions, are the costs of activities
undertaken in satisfaction of the regulatory agency’s conditions per se required to be
capitalized under § 1.263(a)-5 as amounts paid to facilitate a transaction?

CONCLUSION

Where a regulatory agency approves a merger subject to certain conditions, the costs of
activities undertaken in satisfaction of the regulatory agency’s conditions are not per se
required to be capitalized under § 1.263(a)-5 as amounts paid to facilitate a transaction.

FACTS

Taxpayer is a B holding company. Its subsidiaries include regulated C companies
engaged in D. In Year 1, Taxpayer and Company E negotiated the basis for a merger.
Company E owned, among other interests, a regulated C company, Company H. This
proposed merger required the approval of Regulatory Board.

On Date 1, Taxpayer’s Board of Directors approved the proposed merger. On Date 2,
Taxpayer and Company E submitted their first application to Regulatory Board for
approval. There were numerous submissions and hearings on the proposed merger
during the following six months. In Date 3, Taxpayer and Company E entered into a
POSTU-127013-15                               3

settlement with the State K, City J, and certain other interested parties in connection
with the regulatory proceedings. On Date 4, Regulatory Board approved the merger
subject to the following conditions:

1. An Amount N rate credit for each Company H customer. The rate credit reduced
Company H’s revenue by Amount O in Year 2. Taxpayer made an Amount P capital
contribution to Company H to fund the rate credit. The rate credit was made to
customers of record on Date 5.

2. An Amount Q contribution to a customer investment fund. The fund was set up to
provide long-term benefits to Company H customers in the form of V.

3. Payments totaling Amount R to State K for development of an S.

4. A commitment to contribute Amount T per year for U to charitable organizations and
traditional local community support within State K.

On Date 6, Company E was merged into Taxpayer in a stock for stock transaction.
Company H became a wholly-owned subsidiary of Taxpayer.

LAW AND ANALYSIS

Section 162 of the Internal Revenue Code generally allows a deduction for the ordinary
and necessary expenses paid or incurred during the taxable year in carrying on any
trade or business. However, § 263(a) provides that no deduction is allowed for any
amount paid out for permanent improvements or betterments made to increase the
value of any property.

Section 1.263(a)-5(a) of the regulations provides that a taxpayer must capitalize an
amount paid to facilitate certain transactions, including “an acquisition by the taxpayer of
an ownership interest in a business entity if, immediately after the acquisition, the
taxpayer and the business entity are related within the meaning of section 267(b).”
Section 1.263(a)-5(a).

Section 1.263(a)-5(b)(1) of the regulations provides further clarification concerning when
an amount is paid to facilitate a transaction:

       [A]n amount is paid to facilitate a transaction . . . if the amount is paid
       in the process of investigating or otherwise pursuing the transaction.
       Whether an amount is paid in the process of investigating or otherwise
       pursuing the transaction is determined based on all of the facts and
       circumstances. In determining whether an amount is paid to facilitate
       a transaction, the fact that the amount would (or would not) have been
       paid but for the transaction is relevant, but is not determinative.
POSTU-127013-15                               4

The preamble to the proposed regulations (67 F.R. 77701-01, 2003-1 C.B. 373), which
first introduced the concept of costs that facilitate a transaction, provides further
discussion concerning the relevance of the fact that an amount would not have been
paid but for the transaction:

       The facilitate standard is intended to be narrower in scope than a “but
       for” standard. Thus, some transaction costs that arguably are capital
       under a but-for standard, such as costs to downsize a workforce after
       a corporate merger (including severance payments) or costs to
       integrate the operations of merged businesses, are not required to be
       capitalized under a facilitate standard. While such costs may not have
       been incurred but-for the merger, the costs do not facilitate the merger
       itself.

In requiring capitalization of the costs at issue, the examining agent appears to rely
primarily on a but-for test to argue that the costs in question are capital expenditures
under § 1.263(a)-5. The examining agent primarily relies on the conclusion that
Taxpayer would not have incurred the costs at issue but-for the merger. While it would
not be unreasonable to conclude that the costs at issue were incurred in order to obtain
regulatory approval for the merger, the mere fact that costs would not have been
incurred but for the closing of a transaction identified in § 1.263(a)-5(a) is not sufficient
to determine that the costs facilitate the transaction.

As noted in the preamble to the proposed regulations, the facilitate standard is meant to
be narrower than a but-for standard. Section 1.263(a)-5(b) explains that costs are
facilitative if they are incurred in “investigating or otherwise pursuing” the transaction.
The costs specifically identified as facilitative in § 1.263(a)-5 are “deal costs,” that is,
amounts paid to service providers, such as investment bankers, attorneys, and transfer
agents, who undertake financial, legal, investigatory, or administrative activities that are
generally provided exclusively for the purpose of pursuing a transaction but which
otherwise are not general operating costs of the target or acquirer. See § 1.263(a)-5(l),
ex. 1, 2 & 3.

Not all costs incurred because of a merger are facilitative for purposes of § 1.263(a)-5.
For example, the purchase price is not facilitative, nor is an amount paid to another
party in exchange for tangible or intangible property. See § 1.263(a)-5(b)(1). In
addition, as noted in the preamble to the proposed regulations, costs to downsize a
workforce after a corporate merger or costs to integrate the operations of merged
businesses also are not facilitative.

In this case, we do not have sufficient information to determine whether Taxpayer
incurred the costs at issue solely on account of the merger. However, most of the costs
identified are in the nature of annual operating costs that a M company would incur as
part of its normal business operations. For example, regulators commonly require M
companies to charge set amounts to customers or provide customers with various
POSTU-127013-15                             5

credits. Additionally, M companies frequently make annual contributions to charitable
organizations or for local community support.

In the case of the costs identified that may not be in the nature of annual operating
costs, the payments to State K for the development of an S, while not entirely clear, it
appears that the taxpayer may receive the right to intangible property as a result of the
payment. As noted above, under § 1.263(a)-5(b)(1), an amount paid to another party in
exchange for intangible property is not an amount paid to facilitate a merger.

The examining agent sets forth an alternative argument based on the fact that
§ 1.263(a)-5(e)(2)(iv) lists “obtaining regulatory approval” as an amount paid that is
“inherently facilitative.” Under § 1.263(a)-5(e)(2)(iv), obtaining regulatory approval
includes “preparing and reviewing” regulatory filings. It also includes attorneys’ fees to
defend against lawsuits filed by regulators to halt a transaction, even if those fees are
incurred after the transaction is completed. See § 1.263(a)-5(l), ex. 10. The examining
agent asserts that because Regulatory Board was required to approve the proposed
merger and ordered Taxpayer to pay the costs in question as a condition to its approval,
these costs are included with the costs incurred in obtaining regulatory approval.

The costs of obtaining regulatory approval include the costs of preparing for and
appearing before a regulatory board. The phrase “regulatory approval” should not be
read so broadly that it includes any and all costs to address conditions that might be
imposed by regulators.

In this case, the costs at issue appear to be in the nature of annual operating or
investment expenses and not analogous to deal costs paid to service providers who
assist with financing, investigating, documenting, or otherwise administratively
facilitating the transfer of property. As noted above, three of the four costs are
commonly and frequently required by regulators and are annually incurred by M
companies as part of their ordinary and recurring business operations. In addition, the
fact that Company E was previously making annual donations in the same amount as
Company E’s commitment to make future donations suggests a continuation of
Company E’s prior business practice. Finally, as noted previously, the fourth cost
appears to be, at least in part, in exchange for intangible property.

CASE DEVELOPMENT, HAZARDS, AND OTHER CONSIDERATIONS
POSTU-127013-15                              6




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Please call Angella Warren at (202) 317-7003 if you have any further questions.




                                   By: _____________________________
                                       Lewis K Brickates
                                       Chief, Branch 1
                                       Associate Chief Counsel
                                       (Income Tax & Accounting)