Unsupported fee estimates did not permit deduction of acquisition costs

Plain-English summary

A taxpayer paid an investment banker a success-based fee for a completed acquisition and did not elect the Revenue Procedure 2011-29 safe harbor. The banker later estimated that 92% of its time related to identifying a buyer, but admitted it kept no time records and cautioned that the estimates should not be relied on. Chief Counsel concluded that the letter was merely an allocation rather than the supporting documentation required by Treasury Regulation Section 1.263(a)-5(f). A board presentation showed some non-facilitative work but did not allocate the fee or time among activities. The taxpayer therefore had no allowable deduction and had to capitalize the entire success-based fee.

Ruling snapshot

• Question: Did an investment banker's unsupported percentage estimates satisfy the documentation rule for deducting part of a success-based transaction fee?
• Outcome: advice
• Key authorities: IRC §§ 162(a), 263(a); Treas. Reg. § 1.263(a)-5; Rev. Proc. 2011-29

Full text (IRS public release)

           Office of Chief Counsel
           Internal Revenue Service
           Memorandum
           Number: 201830011
           Release Date: 7/27/2018
           CC:ITA:B01:JLTrebat
           POSTN-116851-18

 UILC:     263.00-00

  date:    June 21, 2018

     to:   Jill Yamasaki
           Subject Matter Expert
           (Corporate Distributions & Adjustments Practice Network)

  from:    Brinton Warren
           Branch Chief, Branch 3
           (Income Tax & Accounting)


subject:   Documentation Under Section 1.263(a)-5(f)

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

           ISSUE

           Whether a taxpayer can satisfy the documentation requirements under § 1.263(a)-5(f) of
           the Income Tax Regulations by providing a letter from an investment banker that
           estimates the percentage of time spent on facilitative and non-facilitative activities and
           includes a caveat stating the letter should not be relied on as the investment banker
           does not keep time records?

           CONCLUSION

           No, a taxpayer cannot satisfy the documentation requirements under § 1.263(a)-5(f) by
           providing a letter from an investment banker that estimates the percentage of time spent
           on facilitative and non-facilitative activities and includes a caveat stating the letter
           should not be relied on as the investment banker does not keep time records.

           FACTS

           In -------, Taxpayer engaged Investment Banker to explore a possible sale of Taxpayer
           and to identify potential buyers. The engagement letter provided that Taxpayer would
           pay Investment Banker a fee, determined as a percentage of the total transaction
POSTN-116851-18                                          2

consideration, upon successful closing of the transaction (success-based fee).
Investment Banker’s fee was not based on an hourly rate, but was based on a number
of factors, including Investment Banker’s experience.

Investment Banker identified a number of potential buyers, performed services related
to vetting the potential buyers, and ultimately recommended one buyer to Taxpayer’s
Board of Directors. Taxpayer’s Board of Directors approved the buyer. Investment
Banker performed other services until successful closing of the transaction. The
transaction successfully closed in ------- and Taxpayer owed Investment Banker a fee
for its services.

After the closing, Taxpayer sent Investment Banker a letter asking Investment Banker to
estimate the amount of time it spent on various activities relating to the transaction. In
the letter, Taxpayer advised that the day Taxpayer’s Board of Directors approved the
transaction is the “bright line date.”

In response, Investment Banker sent Taxpayer a two-page letter stating that, as
Taxpayer is aware, Investment Banker did not keep time records and Investment
Banker’s fee was not based on an hourly rate. Investment Banker stated that it could
not provide detailed estimates based on the amount of time spent on certain aspects of
the transaction because it did not keep time records. Investment Banker stated that,
after talking with members of the acquisition team, it could approximate percentages of
time spent on various activities. Investment Banker did not disclose the names of or
contact information for the acquisition team members who were consulted.

In the letter, Investment Banker estimated that approximately 92% of its time was
attributable to identifying a buyer; approximately 2% of its time was attributable to
drafting a fairness opinion; approximately 4% of its time was attributable to reviewing
drafts of the merger agreement; and approximately 2% of its time was attributable to
performing services after the identified bright line date. Investment Banker included a
caveat in the letter stating that the percentages were merely estimates and should not
be relied on by Taxpayer. ---------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------------

On its ------- return, Taxpayer did not elect the safe harbor for allocating success-based
fees that is provided in Revenue Procedure 2011-29. Instead, based on Investment
Banker’s letter, Taxpayer deducted 92% of the success-based fee. On audit, Taxpayer
provided the two-page letter described above as its documentation under § 1.263(a)-
5(f). After Exam requested additional documentation, Taxpayer provided a PowerPoint
presentation that Investment Banker presented to Taxpayer’s Board of Directors. The
PowerPoint presentation contained basic information regarding Taxpayer and explored
possible acquisition strategies.
POSTN-116851-18                                3

LAW AND ANALYSIS

Section 162(a) of the Internal Revenue Code (Code) provides that there shall be
allowed as a deduction all the ordinary and necessary expenses paid or incurred during
the taxable year in carrying on any trade or business.

Section 263(a)(1) provides that no deduction shall be allowed for any amount paid out
for new buildings or for permanent improvements or betterments made to increase the
value of any property or estate.

Section 1.263(a)-5(a) provides, in part, that a taxpayer must capitalize an amount paid
to facilitate an acquisition of a trade or business, a change in the capital structure of a
business entity, and certain other transactions.

Section 1.263(a)-5(b) provides, in part, that an 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.

Section 1.263(a)-5(e)(1) provides, in part, that, except for certain inherently facilitative
amounts listed in § 1.263(a)-5(e)(2), an amount paid by the taxpayer in the process of
investigating or otherwise pursuing a covered transaction facilitates the transaction only
if it relates to activities performed on or after the earlier of the date a letter of intent or
similar communication is executed or the date on which the material terms of the
transaction are authorized or approved by the taxpayer’s board of directors (the “bright
line date”).

Section 1.263(a)-5(e)(2) provides a list of amounts that are inherently facilitative
regardless of when the activities are performed, which includes, inter alia, amounts paid
for securing a fairness opinion.

Section 1.263(a)-5(e)(3) provides that the term “covered transaction” means the
following transactions:

(i) A taxable acquisition by the taxpayer of assets that constitute a trade or business;

(ii) A taxable acquisition of an ownership interest in a business entity (whether the
taxpayer is the acquirer in the acquisition or the target of the acquisition) if, immediately
after the acquisition, the acquirer and the target are related within the meaning of
section 267(b) or 707(b); and

(iii) A reorganization described in section 368(a)(1)(A), (B), or (C) or a reorganization
described in section 368(a)(1)(D) in which stock or securities of the corporation to which
the assets are transferred are distributed in a transaction which qualifies under section
354 or 356 (whether the taxpayer is the acquirer or the target in the reorganization).
POSTN-116851-18                              4


Section 1.263(a)-5(f) provides that an amount paid that is contingent on the successful
closing of a transaction is an amount paid to facilitate the transaction except to the
extent the taxpayer maintains sufficient documentation to establish that a portion of the
fee is allocable to activities that do not facilitate the transaction. This documentation
must be completed on or before the due date of the taxpayer’s timely filed original
federal income tax return (including extensions) for the taxable year during which the
transaction closes. The documentation must consist of more than merely an allocation
between activities that facilitate the transaction and activities that do not facilitate the
transaction, and must consist of supporting records (for example, time records, itemized
invoices, or other records) that identify—

(1) The various activities performed by the service provider;

(2) The amount of the fee (or percentage of time) that is allocable to each of the various
activities performed;

(3) Where the date the activity was performed is relevant to understanding whether the
activity facilitated the transaction, the amount of the fee (or percentage of time) that is
allocable to the performance of that activity before and after the relevant date; and

(4) The name, business address, and business telephone number of the service
provider.

In this case, Taxpayer was acquired in a transaction to which § 1.263(a)-5 applies and,
thus, Taxpayer was required to capitalize the costs incurred to facilitate the transaction.
Section 1.263(a)-5(f) specifically provides that an amount paid that is contingent on the
successful closing of a transaction is an amount paid to facilitate the transaction, and
must be capitalized, except to the extent the taxpayer maintains sufficient
documentation to establish that a portion of the fee is allocable to activities that do not
facilitate the transaction.

Section 1.263(a)-5(f) provides that the documentation (1) must consist of more than
merely an allocation between activities that facilitate the transaction and activities that
do not facilitate the transaction, and (2) must consist of supporting records that identify
the activities performed, the amount of the fee or percentage of time that is allocable to
each of the activities, the date of the activity, if relevant, and the name, address, and
phone number of the service provider.

Revenue Procedure 2011-29 provides a safe harbor election for allocating success-
based fees paid in a business acquisition or reorganization described in § 1.263(a)-
5(e)(3) (“covered transaction”). In lieu of maintaining the documentation required by
§ 1.263(a)-5(f), electing taxpayers may treat 70% of the success-based fees as an
amount that does not facilitate the transaction, and the remaining 30% must be
capitalized as an amount that facilitates the transaction. This safe harbor was provided,
POSTN-116851-18                              5

in part, to incentivize taxpayers to make the election rather than attempt to determine
the type and extent of documentation required to establish that a portion of a success-
based fee is allocable to activities that do not facilitate a covered transaction.

Here, Taxpayer did not elect Revenue Procedure 2011-29. Therefore, Taxpayer must
satisfy the documentation requirements of § 1.263(a)-5(f) or the amount deductible is
zero. Investment Banker’s two-page letter, however, is merely an allocation between
activities that facilitated and did not facilitate the transaction, which § 1.263(a)-5(f)
specifically forbids. Because the two-page letter is merely an allocation, it cannot
satisfy the documentation requirements. Accordingly, Taxpayer must capitalize 100%
of the success-based fee.

Taxpayer attempted to provide time estimates from Investment Banker even though
Taxpayer knew that Investment Banker did not keep time records. Section 1.263(a)-
5(f)(2) does not require a taxpayer’s supporting records to identify the percentage of
time that is allocable to each activity. Section 1.263(a)-5(f)(2) requires the supporting
records to identify the amount of the fee that is allocable to each activity (percentage of
time is just in a parenthetical).

The estimated allocation letter from Investment Banker has no effect under the rules of
§ 1.263(a)-5(f). Without other documentation, Taxpayer’s deduction is zero. While the
PowerPoint presentation may provide some evidence that Investment Banker
performed non-facilitative services, it also has no effect under the rules of § 1.263(a)-
5(f) because it does not identify the amount of the fee or percentage of time that is
allocable to each activity performed by Investment Banker.

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

Please call                if you have any further questions.