Government Clarifies Position on Investigatory Costs

Taxpayers often incur substantial "investigatory" costs before entering into a major transaction such as an acquisition or merger. Historically, taxpayers have looked to judicial authorities such as Briarcliff Candy, 475 F2d 775 (2d Cir. 1973) and NCNB, 684 F2d 285 (4th Cir. 1982), as well as the legislative history associated with the enactment of Sec. 195, for guidance as to when (or if) investigatory costs in an acquisition transaction may escape capitalization.

Taxpayers have been forced to reconsider their reliance on these authorities in the wake of INDOPCO, Inc., 503 US 79 (1992), causing them to question whether the broad capitalization doctrines suggested by the Supreme Court have in effect nullified much of the earlier guidance. Until recently, no specific guidance was available to help taxpayers assess the impact of INDOPCO on the characterization of investigatory costs incurred in connection with a major transaction.

Norwest

In March 1999, the Tax Court analyzed the treatment of investigatory costs in a business expansion context in the post-INDOPCO era. In Norwest, 112 TC 89 (1999), a local bank was approached about a possible merger with a large banking institution. Prior to any formal decision to enter into a merger agreement, the local bank spent $83,450 to (1) investigate the products, services and reputation of the acquiring bank, (2) ascertain whether the merger would be a viable business combination and (3) ascertain whether the proposed transaction would benefit the community.

The bank argued that these costs were deductible investigatory costs under Sec. 162, because they were incurred prior to a decision to enter into the transaction. The Tax Court acknowledged that the costs were incurred before and incidental to the subsequent acquisition. Nonetheless, it ruled that the costs were sufficiently related to the subsequent merger and should be capitalized as part of the overall transaction. The Tax Court stated it "read INDOPCO to have displaced the body of law set forth in Briarcliff Candy and its progeny insofar as they allowed deductibility of investigatory costs in a setting similar to that at hand."

The taxpayer appealed to the Eighth Circuit. Pending the decision on appeal, the Tax Court's decision appeared to require investigatory ex-penses to be capitalized—even if the costs are incurred prior to a decision to enter the transaction and related only distantly to the subsequent acquisition event.

Rev. Rul. 99-23

Less than two months after Norwest, the IRS released Rev. Rul. 99-23, which specified a "whether and which" test (originally set forth in Rev. Rul. 77-254) to distinguish start-up investigatory costs subject to amortization under Sec. 195 from capital acquisition costs under Sec. 263. Specifically, the ruling held that expenditures incurred in the course of a general search for or investigation of an active trade or business to determine whether to enter into a transaction and which new business to enter into qualify as investigatory costs, eligible for amortization as Sec. 195 start-up expenditures.

To many, the holding of Rev. Rul. 99-23 appeared to be in direct conflict with Norwest. This conflict generated questions as to how the government would approach the issue in the future.

DOJ Brief

The government recently clarified its position on investigatory costs in a Department of Justice (DOJ) brief filed in November 1999 with the Eighth Circuit in conjunction with the Norwest appeal. In its brief, the government concedes the deductibility of the investigatory expenses incurred by the taxpayer in Norwest:

Rev. Rul. 99-23 effectively resolves much of the uncertainty concerning the treatment of costs incurred in investigating the possible acquisition of a business. As relevant here, the ruling is premised on the view that costs such as the $83,450 of investigatory expenses at issue in the present case are allowable as deductions where, as here, such cost is incurred in investigating the possible acquisition of a business in the same field as the business in which the taxpayer is already engaged.

The brief goes on to explain:

[B]ecause Rev. Rul. 99-23 was issued after the Tax Court rendered its decision in the present case, the Tax Court's decision does not reflect the Commissioner's current position on this issue. Accordingly, the Commissioner does not now dispute that [the taxpayer] is entitled to deduct investigatory costs in the amount of $83,450.

The DOJ brief also requests that the case be remanded to allow the taxpayer to deduct the investigatory costs. Various arguments in the brief appear to acknowledge the government's intention to adopt definitively the "whether and which" test set forth in Rev. Rul. 99-23. Specifically, the government recognized that certain investigatory-type costs incurred prior to a taxpayer's decision to enter into a transaction with a specific party (i.e., the "whether and which" test) should be characterized as ordinary and necessary expenses.

In the future, disputes between taxpayers and the Service are certain to arise over application of the "whether and which" decision point in characterizing certain transaction costs. Nonetheless, the government's concessions in the DOJ brief should support disregarding the Tax Court's analysis in Norwest as it relates to deductibility of investigatory costs. Going forward, taxpayers now should focus on a "whether and which" analysis, as described in Rev. Rul. 99-23, in seeking to properly characterize investigatory costs.

From Dennis Tingey, CPA, J.D., Washington, DC