Strict IRS Regulatory Requirements Could Derail Your Plans: IRS Memo Denies Taxpayer’s Deduction of Investment Banking Fees

The IRS recently published an Office of Chief Counsel Memorandum, ILM 201830011, in which a taxpayer’s entire success fee paid to an investment bank had to be capitalized instead of deducted. The memo concluded that documentation provided by the investment bank in a sell-side transaction did not satisfy the requirements in Treas. Regs. Section 1.263(a)-5(f). While the IRS has provided a safe-harbor for deducting success-based fees paid to investment banks, taxpayers must either comply with the requirements of the Revenue Procedure or satisfy the stricter regulatory requirements in order to deduct those fees.

Generally, under the Section 263 regulations, costs incurred in an acquisition are treated as either “non-facilitative” (i.e. deductible currently) or “facilitative” (i.e. capitalized over multiple tax years). Certain “investigatory” activities that take place before the “bright-line date” – usually the earlier of the signing of a letter of intent or approval of the material terms of the transaction – can be deducted currently by the taxpayer, whereas services provided by an investment bank after the “bright-line date” must be capitalized.

As provided in ILM 201830011, the taxpayer requested documentation from the investment bank after the transaction closed, supporting its position that 92 percent of the fee paid to the investment bank amounted to non-facilitative costs. The investment bank then provided the taxpayer with a letter including an estimated percentage of its time spent on facilitative and non-facilitative activities. The letter further provided a caveat that it should not be relied on as the investment banker did not keep time records. Rather than availing itself of the safe-harbor provided in Rev. Proc. 2011-29 (which allows a taxpayer to allocate 70 percent of the success-based fee paid to an investment bank as non-facilitative costs), the taxpayer claimed that 92 percent of the fee was non-facilitative (i.e. 92 percent of its time spent in connection with the transaction was attributable to identifying a buyer). In this instance, the IRS determined that the record-keeping requirements outlined in Treas. Regs. Section 1.263(a)-5(f), which specifically states that “documentation must consist of more than merely an allocation between activities that facilitate the transaction and activities that do not facilitate the transaction,” were not followed. Further, the IRS found that the required supporting records (which consisted of a slide-deck prepared by the bank for the board) did not satisfy the record-keeping requirements. As a result, the IRS concluded the taxpayer’s current deduction was zero since the taxpayer did not comply with the requirements under Treas. Regs. Section 1.263(a)-5(f).

Considerations for Future Transactions

Companies currently exploring a transaction should consider taking the following steps:

• Seek contemporaneous documentation from the investment bank which includes supporting records of its “non-facilitative” activities
• Consider including the periodic delivery of the information provided above in the applicable engagement letter that is entered into with the investment bank
• Consider collecting and retaining time-records, correspondence and similar supporting documentation from other advising professionals (e.g. accounting firms and law firms) which detail interactions, time and details of activities spent with the investment bank leading up to, and following, the signing of an LOI or agreement on material terms of a transaction
• Legal advisors should be cognizant of specifically referring to communications and activities with investment banks in time entries for a transaction
• If sufficient documentation is not available to substantiate an allocation above 70 percent of non-facilitative costs, taxpayers can avail themselves of the 70 percent safe-harbor in Rev. Proc. 2011-29