Expenditures Required by Regulatory Agency to Obtain Approval for Merger Were Not Automatically Required to Be Capitalized

Should a corporation that was required to incur certain costs to obtain regulatory approval for a merger be required to capitalize those costs as facilitative costs under IRC §1.263(a)-5(a)?  In Chief Counsel Advice 201713010 the IRS National Office decided the answer was no.

In this case the regulatory board required the following steps to be taken to approve the merger:

  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.

Reg. §1.263(a)-5(a) provides that a taxpayer must capitalize amounts paid to facilitate certain transactions, in this case an acquisition in an ownership interest in certain business entities.

Reg. §1.263(a)-5(b)(1) defines an amount paid to facilitate a transaction as:

. . . 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.

The memorandum goes on to cite further clarification of “facilitative” from the preamble to the regulations:

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.

Perhaps not surprisingly to those in tax practice, this issue arose because an agent believed that all of these costs were facilitative.  But the memorandum, relying on the above rejection of a “but for” test, disagreed.

The memorandum notes:

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.

The memorandum goes on to note:

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.

The agent had a second theory under which he believed these costs should be capitalized even if the “but for” test for capitalization was rejected.  Reg. §1.263(a)-5(e)(2)(iv) states that the costs of “obtaining regulatory approval” are inherently facilitative costs that must be capitalized.  The agent’s argument is that the taxpayer had to obtain regulatory approval for the merger and the regulatory agency demanded the costs in question be incurred in order to obtain that approval.  Thus, such costs should, in the agent’s view, be capitalized and not be available to be expensed.

However, the memorandum does not agree that “costs of obtaining regulatory approval” should be read so broadly.  As the memorandum notes:

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.

The memorandum does not hold that the four items cited above can be immediately charged off—they still must qualify as deductible under other provisions of the law.  But the memorandum does conclude that these costs are not automatically capitalized under the intangible capitalization provisions of Reg. §1.263(a)-5.