In Technical Advice Memorandum 202004010[1] the IRS ruled that a taxpayer (Taxpayer) could not treat “post-acquisition synergies” as an intangible asset into which costs incurred by a subsidiary(Target) when Taxpayer purchased it could be capitalized and then written off as an ordinary loss under IRC §165(a) when the Taxpayer decided to dispose of Target.

The original set of transactions in which the costs in question were incurred are described as follows in the TAM:

Taxpayer is engaged in Business. In Year 1, Taxpayer acquired the stock of Target, a manufacturer of Products, in a taxable reverse triangular merger. In announcing the acquisition of Target stock, Taxpayer and Target stated that the merger was intended to achieve cost synergies that would generate long term growth and increased efficiencies for both entities’ shareholders, customers, and employees. Taxpayer paid approximately $a for Target’s stock, plus assumed liabilities in the amount of $b for a basis of $c.

In connection with the sale of its stock to Taxpayer, Target paid a total of $d in professional fees and administrative expenses. These included payments to several law firms, investment firms, accounting firms, other professional firms, and the Securities and Exchange Commission. Target determined that $e of these fees and expenses were paid in the process of investigating or otherwise pursuing its acquisition by Taxpayer, and therefore, were required to be capitalized as costs of facilitating the acquisition of its trade or business under § 1.263(a)-5(a). Target also determined that $f of these fees were “success-based fees” under § 1.263(a)-5(f) and utilized the safe harbor under Revenue Procedure 2011-29, 2011-18 I.R.B. 746, to allocate those success-based fees between facilitative costs, which were required to be capitalized under section 263, and non-facilitative costs, which may be deducted as business expenses under section 162. Under this safe harbor, Target allocated $g of the success-based fees to non-facilitative costs and deducted these amounts as business expenses under section 162 on its Year 1 short-year Form 1120. In accordance with Rev. Proc. 2011-29, Target allocated the remaining success-based fees to facilitative fees and added those fees to the amounts that it had already determined must be treated as facilitative costs for a total of $h in facilitative costs incurred in its acquisition by Taxpayer.

Taxpayer indicates that, in accordance with section 263, Target capitalized the $h in facilitative fees as an intangible asset on its tax books. Taxpayer stated that “since this asset was not acquired as part of the transaction, but rather created by the transaction, neither Taxpayer nor Target recorded an intangible asset for the $h in facilitative fees pursuant to Statement of Financial Accounting Standards No. 141 (2001) for separate intangibles acquired in business combinations.” In addition, neither Taxpayer nor Target has amortized these fees under any section of the Code or regulations.[2]

Eventually, the Taxpayer determined it no longer wished to hold Target:

During an earnings call on Date 1, Taxpayer's CEO stated that an evaluation of Taxpayer's Products business resulted in a meeting wherein Taxpayer's Board of Directors authorized Taxpayer's executives to advance a plan to divest Taxpayer from its Products business. Afterward, Taxpayer engaged in a sale process involving many potential buyers, and eventually selected Buyer, which Taxpayer's CEO stated would better position the Products business to achieve its full potential.

On Date 2, Taxpayer entered into a stock purchase agreement with Buyer to sell Target to Buyer for $i.[3]

The TAM then goes on to describe the tax reporting by the entities involved:

On Date 3, Taxpayer completed the sale of Target to Buyer pursuant to the agreement, resulting in an estimated capital loss of $j. On its consolidated corporate tax return for its taxable year ending on Date 4, when calculating the separate taxable income of Target under § 1.1502-12, Taxpayer claimed a section 165(a) loss deduction for Target of $h and reduced Target’s separate taxable income by $h, representing the value of the administrative and professional fees capitalized under section 263(a). Taxpayer then included Target’s separate taxable income in Taxpayer’s consolidated taxable income under § 1.1502-11(a)(1). Because Taxpayer’s deduction under section 165(a) reduced Target’s separate taxable income, Taxpayer reduced its basis in Target stock by a corresponding amount under the investment adjustment rules of § 1.1502-32. The investment adjustment resulted in a lower basis in Target stock and, as a result, a reduced capital loss on the sale of Target.[4]

By taking this position, the parent converted a portion of the capital loss on the disposal of Target into an ordinary loss (that loss serves to reduce the basis of Target).  It’s likely the parent did not have sufficient capital gains to absorb that loss—and very possible the loss would expire before it could be offset against capital gains.  For C corporations, capital losses are first carried back three years, then forward five years.  If the loss can’t be used up by the end of that fifth year, it’s lost for good.[5]

IRC §263(a) governs the capitalization of various costs.  For purposes of amounts capitalized as an intangible, the TAM outlines guidance found in Reg. §1.263(a)-4:

Section 1.263(a)-4(b)(1) provides that, in general, a taxpayer must capitalize: (i) an amount paid to acquire an intangible, (ii) an amount paid to create an intangible, (iii) an amount paid to create or enhance a separate and distinct intangible asset, (iv) an amount paid to create or enhance a future benefit identified in the Federal Register or in the Internal Revenue Bulletin as an intangible for which capitalized is required under this section, or (v) an amount paid to facilitate the acquisition or creation of an intangible described in (i) through (iv) of this paragraph.

Section 1.263(a)-4(b)(3)(i) provides that the term separate and distinct intangible asset means a property interest of ascertainable and measurable value in money’s worth that is subject to protection under applicable state, federal or foreign law and the possession and control of which is intrinsically capable of being sold, transferred or pledged (ignoring any restrictions imposed on assignability) separate and apart from a trade or business.[6]

A separate regulation (Reg. §1.263(a)-5) deals with capitalizing amounts paid to facilitate a business acquisition or reorganization. The TAM describes the application of this provision as follows:

Section 1.263(a)-5 provides that a taxpayer must capitalize an amount paid to facilitate a business acquisition or reorganization transaction described in § 1.263(a)-5(a), which includes, among other transactions, an acquisition of an ownership interest in the taxpayer (other than an acquisition by the taxpayer of an ownership interest in the taxpayer, whether by redemption or otherwise). Section 1.263(a)-5(a)(3).

Section 1.263(a)-5(g) provides for the treatment of facilitative costs capitalized under §1.263(a)-5(a). Although § 1.263(a)-5(g)(2) provides rules for the treatment of the acquirer and target corporations in taxable acquisitive transactions that involve asset acquisitions, § 1.263(a)-5(g) expressly reserves on the treatment of target’s facilitative costs in a taxable stock acquisition.[7]

The TAM notes that the taxpayer agreed that the costs incurred could not qualify as a separate and distinct intangible as defined in Reg. §1.263(a)-4(b)(3)(i).  Rather the taxpayer argued for the following support for its position that Target had a “post-acquisition synergies” intangible:

Taxpayer argues that Target paid these amounts to create a separate and distinct intangible asset in the form of the synergistic benefits that Target expected to receive from its combination with Taxpayer. Taxpayer contends that these benefits arose from Target’s access to Taxpayer’s markets, research, quality and innovation platforms, management approaches, and supply chain productivity tools. Under this analysis, Taxpayer argues that the administrative and professional fees paid by Target in connection with Taxpayer’s acquisition of its stock created a separate and distinct intangible asset that was properly capitalized by Target, but this asset became useless to Target at the termination of its relationship with the taxpayer, that is, when Taxpayer sold Target’s stock to Buyer.[8]

The Taxpayer claimed that this conclusion follows the Supreme Court’s decision in the case of INDOPCO, Inc. v. Commissioner, 503 U.S. 79.  That case dealt with costs incurred in a friendly take-over, ruling they had to be capitalized for reasons that included the synergistic benefits expected to be received if the transaction was completed.  Thus, per the TAM, the taxpayer took the following position:

Taxpayer contends that in Target’s case, these synergistic benefits comprised a separate asset that is properly recoverable at the end of the asset’s useful life, consistent with the premise of INDOPCO. Taxpayer also argues that, by not providing regulations that specifically address the treatment of a target’s capitalized facilitative costs in taxable stock acquisitions, the IRS has implicitly sanctioned alternative treatments, such as “treating such costs as creating a new asset the basis of which may or may not be amortizable.” See Notice 2004-18, 2004-11 I.R.B. 605 (requesting comments on the tax treatment of capitalized facilitative costs).[9]

The TAM disagrees with this position, finding that the treatment has been addressed by the IRC §263 regulations and case law that has developed under those regulations.  Under Reg. §1.263(a)-5 these costs must be capitalized.[10]

There was another key issue—had there been a “closed and completed” transaction where the resulting asset (whatever that asset might be) was worthless?.  The TAM answered that question in the negative.

The TAM’s prior finding that this was a corporate restructuring payment rather than an asset tied directly to benefits received in being owned by the parent is key in the analysis.  The Taxpayer argued the asset was worthless due to loss of synergistic benefits, noting:

Taxpayer argues that Target’s previously capitalized fees are deductible as a loss to Target under section 165 because the asset created by the capitalization of these fees, that is, the synergistic benefits, became worthless to Target when Taxpayer sold Target’s stock. Taxpayer contends that its divestiture of Target’s business comprised the identifiable event that closed the transaction and fixed Target’s loss. Taxpayer relies on Echols v. Commissioner, 935 F.2d 703 (5th Cir. 1991), motion for reh’g denied, 950 F.2d 209 (5th Cir. 1991), which supported the use of the worthlessness test as an alternative to a finding of abandonment, to support a loss under section 165. In Echols, the court concluded that the petitioners could properly claim a loss under section 165 for their partnership interest based on their showing of an overt abandonment of the interest, or alternatively, based upon their showing that the partnership interest was subjectively worthless at the time of an objectively identifiable event. Id. at 706-07. Using this approach, Taxpayer contends Target’s subjective determination that its asset was worthless was evidenced by Taxpayer’s announcement that it planned to divest Target’s business, and the identifiable event occurred, and the loss was sustained, when the Taxpayer sold Target’s stock to Buyer.[11]

But the TAM had already concluded there was no “synergistic benefits” intangible, so not surprisingly, it concluded that the loss of the benefit wasn’t relevant.  Rather, the TAM concludes only an abandonment of Target’s business by Target would have rendered these expenses available for a deduction:

If the purpose of the expenditure has to do with the enhancement of a corporation’s operations, then the useful life of the expenditures would be measured by the duration of those operations. See INDOPCO, 503 U.S. at 83-84. Under these circumstances, a taxpayer would generally not be permitted to recover these costs until the dissolution of the business enterprise or until the occurrence of another event that ends the useful life of the business. See id. In the current case, Taxpayer has not shown that Target abandoned its business or that Target’s business operations were dissolved.[12]

The TAM noted that simply because the parent decided to no longer continue to hold Target did not demonstrate that Target’s business was worthless:

Taxpayer’s announcement of its decision to divest may have reflected Taxpayer’s financial difficulties but did not demonstrate Target’s determination that its business was worthless. Assets may not be considered worthless, even when they have no liquidated value, if there is a reasonable hope and expectation that they will become valuable in the future. See Lawson v. Commissioner, 42 B.T.A. 1103, 1108 (1940); Morton v. Commissioner, 38 B.T.A. 1270, 1278 (1938), aff’d, 112 F.2d 320 (7th Cir. 1940); Rev. Rul. 77-17, 1977-1 C.B. 44. Further, Taxpayer’s sale of Target’s stock to Buyer may have been a taxable event to Taxpayer but did not represent a closed or completed transaction upon which Target could claim a loss under section 165. In fact, after the sale, Target continued to exist as a corporation and continued to operate its Products business under Buyer. A deduction is not allowable under section 165 if a taxpayer intends to hold and preserve property for possible future use or to realize potential future value from the property. Rev. Rul. 2004-58, 2004-24 I.R.B 1043 (citing A.J. Indus. Inc. v. United States, 503 F.2d 660, 670 (9th Cir. 1974)).[13]

Thus, the TAM concluded that no §165(a) loss was allowed on the consolidated return and, as well, the capital loss from the disposition of Target had to be increased by that disallowed ordinary loss.[14]

[1] TAM 202004010, January 24, 2020, https://www.irs.gov/pub/irs-wd/202004010.pdf (retrieved January 27, 2020)

[2] TAM 202004010, p. 3

[3] TAM 202004010, pp. 3-4

[4] TAM 202004010, p. 4

[5] IRC §§1211(a), 1212(a)

[6] TAM 202004010, p. 4

[7] TAM 202004010, pp. 5-6

[8] TAM 202004010, p. 5

[9] TAM 202004010, pp. 5-6

[10] TAM 202004010, p. 6

[11] TAM 202004010, p. 8

[12] TAM 202004010, p. 9

[13] TAM 202004010, p. 9

[14] TAM 202004010, p. 9