IRS Proposes Changes to the Tax Treatment of Certain M&A Costs for Consolidated Groups
The Internal Revenue Service (IRS) recently issued proposed regulations under the consolidated return rules, which, if adopted, will change the manner in which certain income and expense items in M&A transactions are allocated between the selling and purchasing groups. These changes do not apply to all M&A transactions, but only to those transactions where a target corporation is leaving or joining a consolidated group.
Under the current consolidated return regulations, there is an “end of day rule” that applies when a target corporation becomes or ceases to be a member of a consolidated group. Under this rule, a target corporation becomes or ceases to be a member of the consolidated group at the end of the day of the acquisition and tax items relating to the acquisition date itself are reported in the taxable year of the target corporation that ends on the acquisition date. The end of day rule means that tax deductions that occur on the acquisition date itself are allocated to the selling parties, not the purchasing parties.
The current regulations contain two important exceptions to the end of day rule. First, if the target corporation is an S corporation that is joining a consolidated group, the former S corporation becomes a member of the consolidated group at the beginning of the acquisition date and its tax year ends at the end of the preceding day. This exception, which is known as the “previous day rule,” eliminated the need for the former S corporation to file a one-day C corporation return for the date of the acquisition.
The second exception is known as the “next day rule.” Under this rule, if the target corporation is involved in a subsequent transaction on the acquisition date that is “properly allocable” to the period after the acquisition date, then the target corporation and its affiliates must treat the subsequent transaction as occurring on the day following the acquisition date. This rule was adopted to prevent an acquiring consolidated group from shifting to the selling parties tax items that occurred on the acquisition date but subsequent to the acquisition of the target corporation, such as the resale of the target corporation on the acquisition date by the acquiring consolidated group. Whether an item is properly allocable to the period after the acquisition date is based on a variety of facts and circumstances.
The proposed regulations focus principally on changes to the next day rule and the previous day rule for former S corporations. However, the key change involving M&A costs is that the next day rule is to be applied on a mandatory basis to “extraordinary items” that result from a transaction that occurs on the acquisition date.
Under the current regulations, extraordinary items include any compensation-related deduction in connection with the acquisition of the target corporation, including deductions from bonus, severance and option cancellation payments. The proposed regulations extend the scope of compensation-related deductions to include a deduction for fees for services rendered in connection with the acquisition of the target corporation.
While the proposed regulations state that extraordinary items are now subject to the next day rule, there is a key exception in the case of compensation-related deductions. To the extent that a compensation-related deduction becomes deductible simultaneously with the event that causes the change in the target corporation’s consolidated group status (i.e., the acquisition of the target corporation), then the compensation-related deduction is deducted by the target corporation on the acquisition date under the end of the day rule (while part of the selling group) and not under the next day rule.
By way of illustration, assume the target corporation is an accrual basis taxpayer for income tax purposes. Target corporation engages a consultant to locate a buyer and a success fee is payable to the consultant on the closing of the sale of target corporation. Also assume that the target corporation is required to make a cancellation payment under its non-qualified option plan to option holders upon a change in control. The parties then agree that both of these payments will be made by the purchasing controlled group after the acquisition date. The proposed regulations state that since target corporation is obligated to pay the success fee and make the cancellation payment as a result of the sale, these compensation-related payments are to be allocated under the end of the day rule to the target corporation, and not to the purchasing controlled group under the next day rule, because these items became deductible on the acquisition date, even though the purchasing controlled group is funding the cost of these items.
The changes made by the proposed regulations restrict the ability of the parties to shift to the purchasing controlled group the tax deductions for M&A transaction expenses when the obligation to pay such expenses has accrued on the acquisition date. The proposed regulations would override any contrary contract provision that shifted the deduction to the purchasing group and require the tax deduction to be claimed on the target corporation’s tax return (before it joins the purchasing corporation’s controlled group).
The proposed regulations are not effective until regulations are published in final form, but it is important to consider the possible application of the rules to future transactions, particularly as they relate to compensation-related deductions in M&A transactions.
If you would like to discuss how any of these reporting obligations may affect your business or personal income tax situation, please contact John Eagan (212.868.4835; email@example.com) or Ryan Udell (215.864.7152; firstname.lastname@example.org).
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