Deducting Investment Banking Fees? What You Need to Know

M&A Alert 2007-6

Key points and opportunities
Private Equity Groups (PEGs), strategic acquirers, and targets alike regularly engage investment banking firms to assist in buying and selling businesses. In almost every case the investment banking firm’s fee is the largest fee incurred in the transaction, and is contingent on the successful closing of a transaction, a so called “success based fee”. In general, costs facilitating a sale or acquisition are subject to capitalization (either amortizable or non-amortizable); however, there are often deductible costs included in the success based fee. Whether a buyer or seller, a taxpayer intent on deducting a success based fee must be vigilant as numerous traps for the unwary exist.

Background
Whether costs incurred investigating and pursuing an acquisition represent deductible costs or costs attributable to and capitalized into the stock or assets acquired (or sold) has been a contentious issue for a number of years. A particularly contentious area has been the treatment of success based investment banking fees.

Guidance
On December 31, 2003 Treasury issued T.D. 9107 with regulations under Code section 263(a) determining capitalization of intangibles (the “INDOPCO Regulations”). Treas. Reg. § 1.263(a)-5 covers capitalization of costs to facilitate the acquisition of a trade or business, capital structure shifts, and certain other transactions. Whether a cost incurred in connection with a covered transaction is subject to capitalization is a facts and circumstances question, and includes costs incurred “in the process of investigating or otherwise pursuing the transaction.” Treas. Reg. § 1.263(a)-5(b)(1).

With respect to success based fees, Treas. Reg. § 1.263(a)-5(f) provides an unfavorable presumption of capitalization and adopts special documentation requirements that if not met require capitalization of the entire success based fee. In addition, the documentation requirement must be satisfied prior to filing the tax return for the year in which the taxpayer claims the deduction. Documentation providing only an allocation between facilitative and deductible fees is not sufficient (i.e. a letter or spreadsheet from the investment banker allocating the percentage of the fee or time spent between activities will not meet this requirement). Rather, the taxpayer must support the allocation with supporting records such as invoices, time sheets, or other records and must identify among other things:

The various activities performed by the service provider
The amount of the fee (or percentage of time) that is allocable to each of the various activities performed
Where the date the activity was performed is relevant … the amount of the fee (or percentage of time) that is allocable to the performance of that activity before and after the relevant date

This documentation standard does not seem overly burdensome; however, investment bankers do not keep detailed reports of the sort required to satisfy the requirement. Therefore, taxpayers are left with the difficult task of attempting to meet the “other records” standard. To meet this standard, taxpayers have generally looked to communication with the investment bankers such as calendar entries, email correspondence, external communications prepared in pursuing the transaction such as offering memorandum, management presentations, and letters from the investment bankers describing the activities performed. Based on the information collected, taxpayers then attempt to determine the amount of the fee that is attributable to deductible activities and what is subject to capitalization. However, this documentation is subject to IRS scrutiny, and it appears that the IRS may be taking a fairly narrow interpretation of the regulation. See Jeffrey R. Hoops, American Institute of Certified Public Accountants, “AICPA Seeks Guidance on Documentation Requirement Under Capitalization Rules”, 2007 TNT 10-72.

Summary
When determining the appropriate treatment of transaction related costs it is important to gain a full understanding of the whom, what, and when with regards to the costs. Not all costs are subject to the same rules or documentation requirements. For success based fees it is very important to address the documentation requirements with investment bankers at the outset of the transaction. While it is unlikely they will deliver detailed invoices or time sheets, an early discussion will allow the investment banker to understand what is needed, why it is needed, and it is always easier to request this type of information prior to the closing of the transaction and payment of the fee. The failure to do so could result in permanent disallowance of deductible expenses.

This bulletin discusses certain general principles of taxlaw. This bulletin does not address all the specific requirements orexceptions that may apply, and it does not apply these general tax principlesto any particular transaction or situation. Accordingly, you should notrely upon the information in this bulletin for the purpose of implementing orreporting any particular transaction, and this bulletin may not be relied uponto provide any relief from any penalties under the Internal Revenue Code or anystate, local, or foreign tax law. Consult your tax advisor regarding theapplication of these general tax principles to your specific situation.

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