Transaction Cost & IRC Sec. 382 Limitation

Posted by kalyani
On June 28, 2024
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By

Kavit Sanghvi

Partner

In the whirlwind of business deals, knowing the ins and outs of the tax implications can give a competitive edge to the business. Understanding how the Internal Revenue Code (IRC) classifies transaction costs and conducting thorough IRC Section 382 analyses can make or break financial outcomes in acquisitions. It’s like cracking a code to unlock maximum tax efficiency and financial gains for the business.

Transaction Costs

Transaction cost analysis involves examining and categorizing various transaction expenses and documenting costs. It involves looking at all the expenses and deciding how they affect taxes. These costs, however, are either permanently disallowed, amortized, immediately deducted or added to the basis in stock/assets acquired according to different rules. Below is a detailed explanation of these provisions:

Treasury Regulations 1.263(a)-5

The regulations apply to amounts paid or incurred to facilitate acquisitions, capital structure changes, and other transactions involving businesses. The taxpayers must capitalize the facilitating business expenses. Facilitating expenses are those that are incurred on or after the cut-off date. In general, costs incurred before the cut-off date are non-facilitative costs, and those incurred after the cut-off date are considered as facilitative costs.

Inherently Facilitative Costs

Generally, facilitative or non-facilitative costs are determined by the cut-off date. Nevertheless, in the case of inherently facilitative costs, these costs are considered to facilitate acquisitions or reorganizations regardless of the dates on which the costs are incurred i.e. the company is required to capitalize costs that are inherently facilitative in nature. The IRC has provided an inclusive list, and any costs that meet the requirement of the definition must be capitalized.

Success Based Fees

Success-based fees are the fees that are contingent upon the completion of a transaction. Typically, these fees must be capitalized unless taxpayers can provide documented evidence showing that a portion of the fees is not related to facilitating the transaction. In compliance with the regulations, comprehensive documentation is required that substantiates various facts, including the date, the activity/service that was performed.

Alternatively, the company may choose to utilize a safe harbor provision (Revenue procedure 2011-29), which allows them to capitalize 30% of the success-based fees and expense the remaining 70%. The utilization of this provision relies on its proper declaration in the original federal tax return. The safe harbor provision may not be available if the taxpayer fails to submit a proper election of the success based fees on its originally filed federal income tax return.

Analysis based on various types of re-organization transactions

Taxable Re-organizations/Sale

The transaction cost incurred must be evaluated to determine whether it is facilitative or non-facilitative cost, directing the decision regarding whether it should be capitalized or expensed appropriately.

Stakeholder

Asset Acquisition

Stock Acquisition

Target Corporation

Costs incurred on an asset acquisition will lead to a reduction in the amount realized while calculating capital gain for the corporation upon the sale of assets.

There are two schools of thought on the tax treatment of this cost.

The cost could be treated as a distribution to shareholders.
An alternate view is that such costs are considered as expenditure. As a result, facilitative costs could be subject to capitalization, whereas non-facilitative costs are to be expensed (Indopco case).

Acquiring Corporation

In case of an asset acquisition, costs incurred towards facilitating the deal are to be capitalized, whereas non-facilitating will be deducted.

In case of a stock acquisition, costs incurred towards facilitating the deal are to be capitalized, whereas non-facilitating will be deducted.

Abandoned Transaction

Abandonment transaction costs require thorough examination to ascertain their treatement for capitalization or deduction. If they satisfy the criteria of being facilitative in nature, they should be capitalized; otherwise, they should be expensed, considering them as non-facilitative in nature. Furthermore, if a planned acquisition is canceled, then any resulting termination fee will be treated as a capital loss.

Section 382 Analysis

Net Operating Losses (NOLs) are often discussed in the context of a company’s standalone operations. When a company reports negative Pre-Tax Income, it accumulates “losses” that can be applied to reduce its taxable income in future periods. Companies that consistently lose money can build up substantial NOL balances, making them attractive to potential acquirers. However, acquiring a target company with a significant NOL balance and utilizing those NOLs is not straightforward. IRC Section 382 imposes restrictions on the use of a target company’s NOLs, which can affect its value and the price an acquiring company is willing to pay. This regulation limits the amount of the target’s NOLs that an acquirer can use to offset its taxable income in the event of a merger or acquisition.
As per Section 382, Target’s NOLs can be redeemed at a maximum annual rate of equity purchase price times the “Adjusted Long-Term Rates.” In the U.S., the IRS determines the “Adjusted Long-Term Rates” on monthly basis.
Recognized Built-In Gains (RBIGs) are pivotal under sections 382 and 384 of the Internal Revenue Code, serving to limit the use of preacquisition losses to offset income post-acquisition. RBIGs specifically refer to income or gains that are considered “built-in” as of the acquisition date and recognized within a five-year period thereafter. The total RBIG that can be recognized in any year is capped by the net unrealized built-in gain (NUBIG), ensuring that the sum of RBIGs over the period does not exceed this limit. Gains from the sale of assets held at the acquisition time are included as RBIGs, limited to the asset’s unrealized built-in gain (UBIG). The burden of proving whether a gain qualifies as an RBIG falls on the corporation, necessitating clear evidence of the asset’s holding period and UBIG. The treatment of installment sales gains as RBIGs was anticipated to be clarified by IRS regulations, with specific guidance pending on the retraction of prior notices.

KNAV can assist in the following ways:

Navigating Transaction Costs and Legal Frameworks: This includes understanding and handling various costs involved in the process, ensuring compliance with relevant regulations, and optimizing the overall transaction structure.
Expertise in Section 382 Compliance: Section 382 plays a pivotal role in limiting the use of pre-change net operating losses post-ownership change. The complexity of Section 382, along with its interactions with other tax provisions and methodologies for calculating built-in gains and losses, necessitates careful planning and compliance. Understanding these rules is vital for corporations undergoing significant ownership shifts, ensuring that their tax strategies are both effective and legally sound. KNAV can provide expertise in understanding and complying with Section 382 regulations.