tax accounting issues in mergers and acquisitions

Tax Accounting Issues in Mergers and Acquisitions

PLI Los Angeles December 5, 2019

Mary Duffy Andersen

Los Angeles, CA

Annette Ahlers Pepper Hamilton LLP

Los Angeles, CA

George Hani Miller & Chevalier Washington, D.C.

Agenda

─ Revenue Recognition under Section 451

─ Business Interest Expense Limitation under Section 163(j)

─ Transaction Costs

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Tax Accounting Issues in Mergers in Acquisitions

─ Have new revenue recognition rules or interest expense limitations created complexities in your transactions? A - Yes, interest expense limitations B - Yes, revenue recognition changes C - Yes, both D – No, not yet

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Revenue Recognition under Sections 451(b) and 451(c)

New Section 451(b)

─ Modification of the All Events Test • New section 451(b) mandates for certain accrual method

taxpayers that “the all events test with respect to any item of gross income (or portion thereof) shall not be treated as met any later than when such item (or portion thereof) is taken into account as revenue in” either:

• An “applicable financial statement” (“AFS”) or • Such other financial statement as the Secretary may specify

─ Proposed regulations under Section 451(b) issued on September 9, 2019 • Establish “AFS Income Inclusion Rule” • Rules generally increase conformity by requiring income recognition

at the earlier of AET or when revenue is reported on an AFS.

─ Generally effective for taxable years beginning after December 21, 2017

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Relevant Amounts

─ Section 451(b) focuses on when an item of gross income is taken into account as revenue in a taxpayer’s AFS

─ Revenue is defined broadly to include all amounts includible in gross income under Section 61 • The characterization of an amount in AFS as revenue is not

determinative • For example, an amount reported as other comprehensive

income in an AFS can be revenue for Section 451(b) purposes

─ Revenue does not include: 1. Amounts collected for a third party; 2. Items to which a taxpayer’s entitlement is contingent on a

future event (rebuttable presumption that items are not contingent); or

3. Reductions for allowances, adjustments, rebates, chargebacks, refunds, rewards, and amounts included in cost of goods sold

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No Cost Offset

─ New section 451(b) applies to “items of gross income” • Gross income is defined in section 61 as income from whatever

source derived, including gains on the sale of property. • To determine gain on the sale of property, the amount realized

on the sale must be matched with the basis of the property sold. • Thus, the item of gross income is not the amount realized but

rather the difference between that amount and the tax basis.

─ Preamble rejects suggestion for cost offset. • Review historic examples that allowed accelerated cost offsets

that were subsequently repealed. • “nothing in the statute or legislative history indicates that in

amending section 451 Congress intended to change sections 461, 263A, or 471.”

• “An allowance for future cost of goods sold, for future estimated costs, or other cost offsets also is inconsistent with sections 461, 263A, or 471, and the regulations under those sections.”

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Realization vs. Recognition

─ TCJA Conference Report explains that new rule does not revise the rules for when an item is realized and, accordingly, does not require recognition of income where the tax realization event has not yet occurred. Conf. Rep. at 428 n. 872. • A paragraph in the Conference Report begins by citing Treasury

regulations under I.R.C. § 61 which provide that “[g]ross income includes income realized in any form.” Treas. Reg. § 1.61-1(a) (emphasis added).

• The paragraph then continues that “[o]nce it is determined that an item of gross income is clearly realized for Federal income tax purposes, section 451 and the regulations thereunder provide the general rules as to the timing of when such item is to be included in gross income.” Conf. Rep. at 426.

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Realization vs. Recognition

─ JCT Slides Released April 2019 • Reiterates that gross income is two-step process:

• Step 1: Section 61 (realization) • Step 2: Section 451 (recognition)

• Realization is any clearly realized accessions to wealth in any form:

• Generally a factual determination • Generally requires there to be a transaction

─ Proposed Regulations – Punt • Regulations themselves do not mention realization • Preamble

• Quotes the language from the Conference Report, but says little more • Emphasizes that the AFS inclusion rules applies to unbilled receivables

included in an AFS without distinguishing between unbilled receivables for goods and unbilled receivables for services.

• No guidance on the line between realization and recognition

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Codification of Advance Payment Rules

─ New section 451(c) codifies a deferral method of accounting for advance payments for goods, services, and other items.

─ Under the new rule, accrual method taxpayers must include advance payments in income when received unless it elects to apply the deferral rules under this new section.

─ If deferral elected, then include in income any amount that is required to be included under section 451(b) and any remaining amount can be deferred for tax purposes to the year following receipt.

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Impact on Prior Rules

─ Generally codified Rev. Proc. 2004-34 • Permits, subject to certain conditions and requirements,

advances payments related to goods or services to be deferred for one taxable year beyond the tax year of receipt.

• Preamble notes: “Because new section 451(c)(1)(B) was intended to generally codify the Revenue Procedure deferral method [in Rev. Proc. 2004-34, as modified], the Treasury Department and the IRS believe that rules similar to those in the Revenue Procedure deferral method are necessary and appropriate for the proper application of section 451(c)”

─ Rejects multi-year alternative under Reg. § 1.451-5 • Indeed, the Conference Report included a statement that the

new section 451(c) “is intended to override any deferral method provided by Treasury Regulation section 1.451-5 for advance payments received for goods.”

• On July 15, 2019, the IRS and Treasury removed Treas. Reg. § 1.451-5 for tax years ending on or after that date

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Definition of Advance Payment

─ A payment will be an advance payment if all three of the following are met: • First, the full inclusion of such payment in the gross income of the taxpayer for the taxable year

of receipt is a permissible method of accounting under this section (determined without regard to this subsection)

• Second, any portion of such payment is included in revenue by the taxpayer in an applicable financial statement for a subsequent taxable year

• Third, such payment is for goods, services, or such other items as may be identified by the Secretary for purposes of this clause

─ Statute excludes from the term “advance payment”: • Rent • Insurance premiums governed by subchapter L • Payments with respect to financial instruments • Payments with respect to warranty or guarantee contracts under which a third party is the

primary obligor • Payments subject to section 871(a), 881, 1441, or 1442 • Payments in property to which section 83 applies, or • Any other payment identified by the Secretary for purposes of this subparagraph

─ See Prop. Reg. section 1.451-8(b)(1) for additional items included and excluded from definition

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Proposed Regulations

─ Non AFS taxpayer can similarly defer income using an “earned” standard

─ 92-day rule for short taxable years: • If advance payment is received in the year before a short taxable

year of 92 days or less, follow AFS and recognize remainder in subsequent year

─ Does not provide an accelerated cost offset as under withdrawn Reg. section 1.451-5 when advance payment had to be included in income in the second year after the year of receipt

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Aerospace Exception

─ Allow exclusion for certain qualifying advance payments.

─ Specifically, advance payments received in connection with commercially significant or high-value goods that take significant amount of time to produce are excluded from the definition of an advance payment provided the TP receives an upfront payment but delivery of the finished goods does not occur for at least two tax years

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Proposed Regulations

─ Non AFS taxpayer can similarly defer income using an “earned” standard

─ 92-day rule for short taxable years: • If advance payment is received in the year before a short taxable

year of 92 days or less, follow AFS and recognize remainder in subsequent year

─ Does not provide an accelerated cost offset as under withdrawn Reg. section 1.451-5 when advance payment had to be included in income in the second year after the year of receipt

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Guidance for Method Change Procedures

─ Rev. Proc. 2018-29 • Changes in timing of income recognition

─ Rev. Proc. 2018-60 • Changes in timing of income recognition under new section

451(b)

─ Rev. Proc. 2019-37 • Change in timing of income recognition for adopting Prop. Reg.

section 1.451-3 • Change in timing of Advance Payments for taxpayer with an AFS

adopting Prop. Reg. section 1.451-8(c) or taxpayers without an AFS adopting Prop. Reg. section 1.451-8(d)

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Interest Limitations under Section 163(j)

Business Interest Expense Limitation - Applicability

• Limitation applies to all types of businesses that have average annual gross receipts in excess of $25 million (based on aggregation rules for controlled groups) and all tax shelters as defined in Sec. 461(i)(3)

• Applicable for tax years beginning on or after December 31, 2017 and is applied at the corporate (including S corporation), partnership and sole-proprietorship levels

• Taxpayers with pass-through investments may receive allocations of excess interest expense, excess interest income or excess taxable income

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Business Interest Expense Limitation –Computation

• Interest expense deduction limited to the sum of: - business interest income, - 30% of adjusted taxable income (ATI), and - floor plan financing interest expense

• For taxable years beginning before January 1, 2022, ATI is computed without regard to deductions for depreciation, amortization, and depletion

• Interest deductions that businesses will be able to take under the TCJA essentially will be limited to 30% of taxable EBITDA through 2021 and 30% of taxable EBIT thereafter

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Business Interest Expense Limitation – Planning Points • A Sec. 163(j) carryforward is an important consideration in any

transaction.

• After a disposition of a partnership interest, any Sec. 163(j) limitation carryforward will increase the basis in the partnership interest, thus, potentially reducing capital gain in a transaction, rather than being treated as an ordinary deduction for interest expense at the time it is incurred.

• A Sec. 382 limitation will apply to limit use of Sec. 163(j) carryforwards following a corporate ownership change.

• For businesses in NOLs, a Sec. 163(j) limitation may not impact the cash tax outlay, but an NOL is a more accessible tax attribute to use in the future as compared to a Sec. 163(j) limitation.

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Business Interest Expense Limitation – Accounting Methods Planning • Accounting methods planning can be used to lessen or avoid a Sec.

163(j) limitation.

• Increases in deductions for depreciation, amortization or depletion may increase the ATI addback, thus increasing the amount of interest that can be deducted in the current year.

• This could be accomplished by capitalizing and depreciating or amortizing additional costs, as opposed to expensing the costs at the time incurred.

• This will present a planning technique through 2021 when ATI includes the addback.

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Business Interest Expense Limitation – Accounting Methods Planning • Certain expenditures can either be immediately expensed or

capitalized and recovered over time depending on the method of accounting that a taxpayer selects.

• Examples of items that could electively be capitalized, or areas

where additional capitalization may be warranted include: - software development costs, - research expenditures, - creative property, - additional Sec. 263A costs, - repair and maintenance costs, or - other industry-specific items.

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Business Interest Expense Limitation – Accounting Methods Planning • The ATI calculation includes an addback of allowable deductions for

depreciation, amortization, or depletion, (collectively, the addback).

• The proposed regulations provide that any depreciation or amortization that is capitalized to inventory and recovered through cost of goods sold (COGS) is not treated as a depreciation deduction for purposes of the addback.

• Taxpayers will need to evaluate the amount of depreciation that is reflected in COGS when computing the addback.

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Business Interest Expense Limitation – Accounting Methods Planning • The proposed regulations provide a rule where interest that is

capitalized to an asset is not treated as business interest expense for purposes of the limitation.

• Rather, such capitalized amounts become part of the cost of the property and are recovered based on the cost recovery for the property.

• Examples of interest that could be capitalized to an asset include production period interest under Sec. 263A(f) or a Sec. 266 election to capitalize interest as a carrying charge.

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Business Interest Expense Limitation – Accounting Methods Planning • Given that 100% bonus depreciation is currently in effect,

expenditures that relate to qualified property could be capitalized and recovered immediately by taking bonus depreciation.

• Other expenditures may be able to be recovered over a relatively short period of time.

• As capitalizing and depreciating or amortizing versus immediate expensing will in many cases create an unfavorable timing difference, it is necessary to weigh or model the impact of the unfavorable timing difference against the effect on the ability of the business to deduct interest expense over time.

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Business Interest Expense Limitation – Accounting Methods Planning • The business interest expense limitation does not apply to any

electing real property or farming trade or business or to certain regulated utilities.

• Taxpayers should carefully consider whether excepted activities within a legal entity could be considered a separate trade or business.

• To the extent a taxpayer has one or more excepted trades or businesses along with other trades or businesses, the proposed regulations allow for an asset-based allocation of interest among the trades or business.

• Allocation of interest can be increased to excepted trades or businesses by increasing the basis in assets of the excepted trade or business.

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Business Interest Expense Limitation – Accounting Methods Planning

• The new interest limitation is having a dramatic impact on highly leveraged taxpayers.

• Taxpayers anticipating an interest limitation in 2018 or a future year should consider accounting method changes to optimize their tax position in light of the new rules.

• Most changes will require filing a Form 3115, Application for Change in Accounting Method, or making new elections on the tax return. • Many changes can be made under the automatic consent

procedure, due when the tax return is due.

• Non-automatic changes are due by the end of the taxable year of change.

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Transaction Costs

LB&I Transaction Unit on Transaction Costs in a Corporate Separation • On 10 May 2019, the IRS released a new LB&I

Transaction Unit on Transaction Costs in a Corporate Separation. • In a Section 355 transaction, a distributing corporation

distributes the stock of a controlled subsidiary in a tax-free transaction, such as a spin-off, split-off or split-up (i.e., a corporation separation).

• The Transaction Unit addresses the following: 1. Costs that facilitate the separation transaction, 2. Facilitative costs the distributing corporation capitalized when it

acquired the controlled corporation’s stock in a tax-free transaction, and

3. Facilitative costs the controlled corporation capitalized when the distributing corporation acquired its stock.

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LB&I Transaction Unit on Transaction Costs in a Corporate Separation

• There are three issues examined by the Transaction Unit: 1. In the year the corporate separation was completed, did the distributing

corporation deduct transaction costs that facilitated the transaction? • IRS considerations (as provided in the Transaction Unit):

• The transaction costs to facilitate the corporate separation should be capitalized under Treas. Reg. 1.263(a)-5(a)(4);

• The distributing corporation abandoned the corporate separation and sustained a bona fide, uncompensated loss evidenced by closed and completed transactions and fixed by identifiable events, as required under Treas. Reg. 1.165-1(b); and

• The distributing corporation has provided sufficient evidence to support that it is entitled to deduct the transaction costs that facilitated the abandoned corporate separation.

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2. In the year the corporate separation was completed, did the distributing corporation deduct costs it previously capitalized as facilitating the acquisition of the controlled corporation? • IRS considerations (as provided in the Transaction Unit):

• The distributing corporation abandoned the controlled corporation’s stock when it distributed such stock in the corporate separation;

• The corporate separation caused the distributing corporation to sustain a bonafide, uncompensated loss evidenced by closed and completed transactions and fixed by identifiable events, as required under Treas. Reg. 1.165-1(b), with respect to the previously capitalized transaction costs; and

• The distributing corporation has provided sufficient evidence to support that it is entitled to deduct the previously capitalized transaction costs that facilitated its acquisition of the controlled corporation’s stock.

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3. In the year the corporate separation was completed, did the controlled corporation deduct costs it previously capitalized as facilitating the acquisition of its stock? • IRS considerations (as provided in the Transaction Unit):

• The controlled corporation dissolved in the corporate separation; • The synergistic and resource benefits associated with the controlled

corporation’s affiliation with the distributing corporation terminated in the corporate separation;

• The corporate separation caused the controlled corporation to sustain a bonafide, uncompensated loss evidenced by closed and completed transactions and fixed by identifiable events, as required under Treas. Reg. 1.165-1(b), with respect to the previously capitalized costs; and

• The controlled corporation has provided sufficient evidence to support that it is entitled to deduct the previously capitalized costs that facilitated the acquisition of its stock.

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• The release of the Transaction Unit follows the 13 March 2018 announcement of a new LB&I campaign on costs facilitating a Section 355 transaction.

• The release of the Transaction Unit, in conjunction with the LB&I campaign, shows a continued interest by the IRS on transaction costs incurred in corporate separations.

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─ For every transaction, document the costs incurred to preserve the information that relates to the existence of capitalized costs.

─ Determine if the capitalizable transaction costs are added to stock basis, or to the tax basis of a particular asset or group of assets, or are “associated with the business enterprise” (the Indopco position).

─ If a target or an acquiring corporation has these types of capitalized transaction costs, make sure to “carry over” this information if such corporation is merged into another group member, either through liquidation or statutory merger. • Practice Tip: It may be beneficial to prepare a tax basis balance sheet

showing these potential categories of capitalized costs. While there is no amortization, it may assist with documenting their existence.

─ If the business of the target corporation is abandoned or part of other discontinued operations, make sure to review potential abandonment positions that may be taken. • Note that taking an abandonment position will require detailed

analysis of the event and timing of such abandonment, and may require an actual liquidation of the entity.

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Best Practices – Supporting the Recovery of Capitalized Costs

─ Generally, one corporation’s payment of another corporation’s expense does not give rise to a trade or business deduction for the payor corporation. • Interstate Transit Lines v. Comm’r, 319 U.S. 590 (1943)

• A corporation could not take a deduction for the operating deficit that it reimbursed to its subsidiary. Id. at 594.

─ Such payments of another’s obligations are not deductible as ordinary or necessary business expenses because they are not “ordinarily” incurred in the payor’s trade or business. • South Am. Gold & Platinum Co. v. Comm’r, 8 T.C. 1297 (1947)

• A parent holding company could not deduct legal expenses, incurred from negotiating and carrying out a settlement agreement on behalf of its subsidiaries where the subsidiaries acquired additional proprietary rights, as ordinary and necessary business expenses because these expenses were (1) not incurred in carrying out the parent company’s business and (2) were made to hold or acquire capital assets. Id. at 1302.

Allocation of Costs Between Transaction Participants

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─ Courts apply the “direct and proximate benefit” test in determining whether one company’s payment or reimbursement of another company’s expense is deductible or properly taken into account by the paying or reimbursing company.

─ To satisfy the threshold requirements of this test, the taxpayer must prove that the specific services or activities giving rise to the claimed deduction were performed for the taxpayer’s direct and proximate benefit.

Exception: The “Direct and Proximate Benefit” Test

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Plano Holding LLC v. Commissioner, T.C. Memo. 2019-140 • Facts

• In 2010, Plano Molding Co. (Plano), an Illinois plastics manufacturer, retained Robert W. Baird & Co., Inc. (Baird) as its financial advisor to assist with a potential sale of the company. No sale took place at that time.

• In 2012, Baird suggested Plano as a potential acquisition candidate to the Ontario Teachers’ Pension Plan Board (OTPP), a Canadian corporation and large institutional investor.

• Baird attempted to set up a lunch meeting between OTPP and Plano’s shareholder, Tinicum. While the lunch never transpired, OTPP and Tinicum later discussed the potential acquisition by phone. Baird had no further involvement in the acquisition that followed.

• On July 26, 2012, Plano retained Harris Williams LLC (Harris

Williams) as its exclusive investment banker and financial advisor.

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Plano Holding LLC v. Commissioner, T.C. Memo. 2019-140

• On November 20, 2012, Plano Holding LLC (Holding) and Plano Acquisition LLC, newly formed wholly owned subsidiaries of OTPP, Plano and New Plano Molding, LLC entered into a merger agreement.

• On November 28, 2012, OTPP agreed to pay Baird $1.5 million upon completion of the transaction for suggesting Plano as a potential acquisition candidate. • The agreement provided that Baird’s services were rendered

solely for the benefit of OTPP and the parties’ obligations could not be assigned without Baird’s prior written consent.

• On December 21, 2012, the transaction closed for approximately $240 million. As a result of the acquisition, Plano became a wholly owned subsidiary of Holding.

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• Upon consummation of the transaction, Plano paid fees of $2.89 million to Harris Williams and $1.5 million to Baird. • While the fee paid to Harris Williams was treated as a transaction

expense that reduced the purchase price of Plano, the Baird fee was not treated as a transaction expense that reduced the purchase price.

• Holding filed a consolidated federal income tax return for 2012, in which 70% of the Baird fee paid by Plano was deducted (with the balance capitalized) under the safe harbor election under Revenue Procedure 2011-29.

• The IRS denied the deduction because it noted that Baird did not provide services to Plano or Holding. • As a result, the IRS issued a notice of deficiency of $90,385 and

an accuracy-related penalty of $18,077.

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• Holding • The Tax Court disallowed the deduction holding Plano failed to establish a “direct link” between the benefits it derived from the transaction and the payment.

• The Tax Court sustained the IRS’s deficiency and accuracy-related penalty determinations.

• The Tax Court based its conclusion on Lohrke v. Commissioner, 48 T.C. 679 (1967), which provides that a taxpayer may deduct the payment of another person’s expenses if:

• (1) the taxpayer’s primary motive for paying the other’s obligation is to protect or promote the taxpayer’s own business and

• (2) the expenditure is an ordinary and necessary expense of the taxpayer’s business.

• The Tax Court concluded Plano failed both prongs of this test.

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• Reasoning • With respect to the first prong, there must be a direct nexus between the payment’s purpose and the taxpayer’s business to establish that it made the payment to benefit its business.

• Holding argued that, as a result of Baird’s matchmaking role, Plano was acquired by OTPP, which allowed Plano to expand.

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• The Court rejected this argument finding there was not a direct link between Plano’s acquisition and the payment to Baird because: • Plano and OTPP had already agreed to the merger more than a

week before OTPP contracted to pay Baird; therefore, the merger was not contingent on Plano’s payment of the Baird fee.

• Holding failed to show that there would be “direct and proximate adverse consequences to Plano’s business of manufacturing plastic goods had it not covered OTPP.”

• While Baird played a significant role in the early days of a potential acquisition, there was no benefit to Plano from the Baird payment. Instead, OTPP primarily benefitted from the payment to Baird.

• Therefore, Plano failed the first prong of the Lohrke test.

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• The Taxpayer failed the second prong because the payment was not an ordinary and necessary expense of Plano’s business of manufacturing plastic goods. • The Court noted, neither party suggests that Plano’s payment of

the Baird fee was for Baird’s attempts to find a purchaser for Plano in 2010.

• Rather, the parties “agreed that the Baird payment came about because OTPP felt obligated to Baird for its legwork (in 2012) in identifying a potential acquisition for OTPP.”

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• The Court rejected Holding’s reliance on Square D v. Commissioner, 121 T.C. 168 (2003). • Holding argued that, similar to the facts in Square D, Plano could

not enter a fee agreement with Baird directly. • The Court found that “OTPP acted on its own behalf, not on

behalf of Plano, in agreeing to the Baird payment, thus distinguishing this case from Square D, where the recipient of the benefit was the taxpayer who made the payments and claimed the deduction.”

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• Key takeaways • This case illustrates the importance of developing facts to support the proper location of transaction costs - particularly the “direct and proximate benefit” factor.

• The language in an engagement agreement can significantly affect the benefit analysis.

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• The Tax Court seemingly misapplied the Lohrke line of cases because it seems to conflate the analysis in Lohrke with the “on behalf of” analysis in Square D. • The Square D decision specifically did not apply the Lohrke line of

cases in reaching its conclusions that a target could deduct certain expenses for which the acquirer was originally liable.

• The Square D court applied an “on behalf of” analysis, which it viewed as separate and distinct from the Lohrke line of cases.

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─ A deduction may be available when • an expense directly relates to the taxpayer’s business, and • the taxpayer pays or reimburses such expense.

─ Facts and circumstances determination

─ Requires extensive documentation, including, but not limited to: • Engagement letters for original work • Factual narrative describing the benefit of the services to the

paying taxpayer • Factual discussion on how such services relate to the paying

taxpayer’s business and are not related to the investment aspects of the transaction

• Transaction documents indicating who paid the fees and when such payments were made.

Information Supporting Application of the Direct and Proximate Benefit Test

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tax accounting issues in mergers and acquisitions

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