Sledgehammer, Not Scalpel: IRS Proposes Regulations on M&A Costs
March 13, 2015
PitchBook Dealmakers Column
As was cautioned in a previous Dealmakers column, the IRS issued proposed regulations on March 5 that, if finalized, will result in a seismic shift in the private equity treatment of M&A costs. In most transactions, a target corporation incurs significant transaction costs. Often, the largest of those are for success-based fees paid to an investment banker or PE management company and compensation (e.g., option cancellation payments and transaction bonuses). In general, the majority of these costs are deductible by the target, providing a significant tax shield that is either carried back to obtain a refund of prior taxes or carried forward to offset future taxable income.
When a target is acquired by another corporation and joins in a consolidated tax filing, the parties often agree to apply the "next-day rule" under current law to those transaction deductions, pushing the tax benefit of the costs to the post-transaction tax period. The new next-day rule contained in the proposed regulations eliminates this flexibility and would require the target to report almost all success-based fees and compensation related deductions on the pre-transaction return, regardless of the specific facts. The proposed rules even include an anti-abuse rule to address contract changes made close to the deal with the intent of avoiding the application of the new next-day rule.
While the regulations are not effective until finalized, PE firms have been served notice by the IRS that the current application of the next-day rule to success-based fees and compensation deductions is suspect in their eyes. If the regulations are finalized, it will be a thing of the past. As a result, PE firms should consult their tax advisors when determining the treatment of these costs in future M&A transactions.