IRS Issues Updated Guidance on the Examination of Milestone Payments 

    TAX CLINIC 
    by Catherine Fitzpatrick, CPA, MST, and Carol Conjura, CPA, J.D., Washington 
    Published June 01, 2014

    Editor: Mary Van Leuven, J.D., LL.M.

    Expenses & Deductions

    Taxpayers that incur costs relating to an acquisition or restructuring transaction must generally capitalize the costs that "facilitate" the transaction. Regs. Sec. 1.263(a)-5 provides guidelines for determining whether expenditures facilitate a transaction. For certain acquisitive transactions (or "covered transactions"), this determination may be based on whether the costs were incurred before a "bright-line date." In addition, for success-based fees, i.e., payments to professional service providers that are contingent upon the successful closing of a transaction, taxpayers may apply either the facts-and-circumstances test under the regulations or the safe harbor in Rev. Proc. 2011-29 to determine the portion of the total fees deemed to facilitate the transaction.

    Recently, the IRS's Large Business and International (LB&I) exam division issued a directive, LB&I-04-0114-001 (1/27/14), instructing examiners not to challenge a taxpayer's application of the safe harbor to "eligible milestone payments" (defined below) incurred during the course of a covered transaction if the directive's requirements are satisfied. This directive updates and modifies another directive issued in April 2013, regarding the treatment of milestone payments.

    Success-Based Fees

    Regs. Sec. 1.263(a)-5(a) requires a taxpayer to capitalize amounts paid to "facilitate" (i.e., paid in the process of investigating or otherwise pursuing) several types of transactions, and also requires that all the facts and circumstances be considered in determining whether an amount is paid in the process of investigating or otherwise pursuing the transaction. Except for certain inherently facilitative costs (such as costs of securing an appraisal, structuring and negotiating the transaction, preparing and reviewing the transaction documents, and obtaining regulatory and shareholder approval of the transaction), Regs. Sec. 1.263(a)-5(e) allows an amount to facilitate a "covered transaction" only if it relates to activities performed on or after the earlier of (1) the date on which a letter of intent, exclusivity agreement, or similar written communication (other than a confidentiality agreement) is executed by representatives of the acquirer and the target; or (2) the date on which the material terms of the transaction (as tentatively agreed to by representatives of the acquirer and the target) are authorized or approved by the taxpayer's board of directors (or committee of the board of directors) (the bright-line date). Covered transactions include, among other things, certain taxable acquisitions of an ownership interest in a business entity (whether the taxpayer is the acquirer or the target) and certain reorganizations described in Sec. 368.

    Regs. Sec. 1.263(a)-5(f) generally provides that a success-based fee incurred with respect to a covered transaction is presumed to facilitate the transaction and, thus, must be capitalized unless a taxpayer rebuts the presumption by maintaining sufficient contemporaneous documentation to establish that a portion of the fee is allocable to activities that do not facilitate the transaction (e.g., activities that are not inherently facilitative or occurred before the bright-line date). Because the treatment of success-based fees, including the issue of what constitutes "sufficient documentation," caused confusion and controversy, the IRS published Rev. Proc. 2011-29 to establish a safe-harbor method of accounting for success-based fees. If a taxpayer elects the safe harbor for a transaction, in lieu of maintaining the required documentation, the taxpayer can treat 70% of the success-based fee as a nonfacilitative cost and capitalize the remaining 30%. To make the election, the revenue procedure specifies that the taxpayer must attach a statement to its original federal income tax return for the tax year the fee is paid or incurred, stating that the taxpayer is electing the safe harbor, identifying the transaction, and stating the amounts that are capitalized or deducted as nonfacilitative under the safe harbor, and treat the fees consistently on its tax return.

    Application of Safe Harbor to Milestone Payments

    Chief Counsel Advice (CCA) 201234027 addressed whether nonrefundable milestone payments made to a service provider for activities performed for a covered transaction were considered success-based fees and therefore qualified for the safe harbor. The taxpayer in the CCA retained an investment banker to provide services with respect to a merger, which is a covered transaction under Regs. Sec. 1.263(a)-5(e)(3). Under the terms of the engagement letter, the investment banker was entitled to $10 million upon the successful closing of the transaction. In addition, the taxpayer agreed to pay $1 million upon the signing of the merger agreement and another $1 million upon shareholder approval of the transaction (collectively, the milestone payments). The milestone payments were nonrefundable, but they were creditable toward the amount owed upon the closing of the transaction; accordingly, upon closing, the taxpayer would owe $8 million.

    The CCA concluded that because the nonrefundable milestone payments were not contingent on the successful closing of the transaction but rather were guaranteed payments incurred upon the occurrence of a specific event (other than closing), they did not meet the definition of a success-based fee and did not qualify for the safe harbor. The taxpayer had argued that because the milestone payment earned was creditable against the contingent success-based fee if the transaction closed, it should be treated as part of that fee.

    Despite the conclusion in the CCA, LB&I subsequently chose not to follow it and issued a directive on April 29, 2013 (LB&I-04-0413-002), advising its examiners not to challenge the treatment of "eligible milestone payments" to which a taxpayer has applied the safe harbor. For this purpose, a milestone was defined as an event occurring in the course of a covered transaction, provided the event is either one of the events set forth in the bright-line test discussed above (i.e., signing of a letter of intent, exclusivity agreement, or other similar written communication, or board of directors approval of the transaction) or some specified event other than a successful closing of the transaction, provided the event does not occur before the bright-line date.

    Updated Milestone Directive: LB&I-04-0114-001

    When the April 2013 directive was issued, it was unclear why the definition of "milestone" was limited to events that did not occur prior to the bright-line date. In some situations, this resulted in the same type of milestone payment (e.g., a fairness opinion fee) being afforded different results, depending on when it was earned. The IRS reconsidered its position and concluded the limitation was unnecessary, as indicated in the directive issued on Jan. 27, 2014 (LB&I-04-0114-001), which updates the definition of "milestone" and eliminates the limitation.

    The 2014 directive provides that if the requirements set forth therein are satisfied, LB&I examiners should not challenge a taxpayer's treatment of "eligible milestone payments" made or incurred in the course of a covered transaction for which the taxpayer incurs a success-based fee. For purposes of the directive, the term "milestone" means an event, including the passage of time, occurring in the course of a covered transaction (whether the transaction is ultimately completed or not). The term "milestone payment" means a nonrefundable amount that is contingent on the achievement of a milestone. Finally, the term "eligible milestone payment" means a milestone payment paid for investment banking services that is creditable against a success-based fee.

    The directive advises examiners not to challenge a taxpayer's application of the safe harbor to eligible milestone payments if certain conditions are satisfied. In general, for tax years ended on or after April 8, 2011 (the date the safe-harbor revenue procedure was issued), a taxpayer must have qualified for and timely elected the safe harbor and deducted no more than 70% of any eligible milestone payment incurred in connection with the respective success-based fee on its original tax return for the year in which the liability accrued. In addition, the taxpayer must not be contesting its liability for the eligible milestone payment.

    There are also rules that address tax years ended before April 8, 2011, and situations in which a covered transaction spans multiple tax years and the success-based fee was incurred in a year for which the safe-harbor election could be made, but eligible milestone payments were incurred in earlier tax years. However, in all cases, the directive applies only for amounts deducted on original, timely filed tax returns, and not for refund claims, whether formal or informal.

    Although the directive is not an official pronouncement of law and cannot be used, cited, or relied on as such, a taxpayer that falls into one of the fact patterns described in the directive should have little to no exposure if it applies the safe harbor to its eligible milestone payments. The directive is not all-encompassing, however. Service providers other than investment bankers often earn success-based fees and milestone payments similar to those at issue in the directive. In those cases, the directive does not explicitly apply, although taxpayers may be able to reach agreement with the IRS that it should apply by analogy.

    EditorNotes

    Mary Van Leuven is senior manager, Washington National Tax, at KPMG LLP in Washington.

    For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or mvanleuven@kpmg.com.

    Unless otherwise noted, contributors are members of or associated with KPMG LLP. The information contained in this item is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This item represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP.




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