March 4, 2022
US IRS withdraws LB&I directives on transaction costs
In a memorandum for Large Business and International (LB&I) division employees, the United States (US) Internal Revenue Service (IRS) withdrew various LB&I directives, including some related to transaction costs.
Examination of transaction costs in the acquisition of businesses
The IRS withdrew a directive on the "Examination of Transaction Costs in the Acquisition of Businesses," which was published on 20 May 2005. The IRS determined the directive was obsolete because it did not apply to costs incurred on or after 31 December 2003. This directive instructed examiners to look to examination results of transaction costs before 31 December 2003 (yielding a capitalization range of 50% to 65%) to determine whether an audit of current transaction costs was warranted. The IRS explained that "[t]he passage of time has made the guidance in this directive no longer relevant.”
Examination of success-based fees in the acquisition of businesses
The IRS also withdrew LB&I-04-0511-012, "Examination of Success-Based Fees in the Acquisition of Businesses," published on 28 July 2011, because the directive applies to the examination of transaction costs incurred before 8 April 2011, and it is unlikely that the IRS will examine transaction costs incurred before that date. The directive instructed examiners not to challenge a taxpayer's treatment of success-based fees paid or incurred in tax years ending before 8 April 2011, with respect to a "covered transaction," when the taxpayer's original return position was to capitalize at least 30% of the total success-based fees it incurred on the transaction.
Updated guidance on the examination of milestone payments in the acquisition of businesses
Additionally, the IRS withdrew LB&I-04-0114-001, "Updated Guidance on the Examination of Milestone Payments in the Acquisition of Businesses," published on 27 January 2014, because it prohibited LB&I examiners from challenging taxpayers' treatment of certain "eligible milestone payments." As defined in the directive, an eligible milestone payment is a non-refundable amount paid for investment banking services that is (1) contingent on the achievement of a milestone (whether the transaction is completed or not) and (2) creditable against a success-based fee. For example, a portion of an investment banker fee may be paid upon certain milestones being reached, such as the delivery of a fairness opinion, signing of the transaction documents, or shareholder approval.
As explained in the memorandum, because there is a need for consistent treatment of compliance issues and to address what the IRS termed as taxpayers' "egregious" positions, the LB&I will apply a case-by-case risk assessment that is consistent with the treatment of other compliance issues. The directive's withdrawal is effective for returns filed after 26 January 2022.
As explained in the memorandum, "LB&I directives were issued to provide administrative guidance to LB&I examiners to ensure consistent tax administration, and guidance on matters relating to internal operations." In July 2020, the IRS announced that LB&I would no longer use the industry directive format and that Interim Guidance (IG) memoranda would be the format going forward for procedural guidance. Accordingly, LB&I Policy has been coordinating a process to evaluate all existing directives and to determine the proper placement for the content included in the directives. The IRS determined the directives included in this memorandum were obsolete or should be withdrawn.
The withdrawal of these directives confirms that LB&I directives are not reliance guidance. Accordingly, taxpayers that have taken positions consistent with the LB&I directives will need to reevaluate these positions and consider a FIN 48. Specifically, the withdrawal of LB&I-04-0114-001 on the eligibility of milestone payments for the Revenue Procedure 2011-29 safe harbor election is significant and may result in increased scrutiny of milestone payments by IRS examiners. Before the directive was issued, the IRS issued Chief Counsel Advice (CCA) 201234027 on 27 August 2012, concluding that nonrefundable milestone payments that are creditable to a success-based fee are not, themselves, success-based fees because they are not contingent on the successful closing of the transaction. Therefore, these milestone payments do not qualify for the safe harbor for success-based fees in Revenue Procedure 2011-29, which allows taxpayers to treat 70% of success-based fees as non-facilitative of a "covered transaction."
LB&I chose not to follow the CCA and issued a directive on 29 April 2013 (LB&I-04-0413-002), which was further clarified by LB&I-04-0114-001, advising its examiners not to challenge the treatment of "eligible milestone payments" to which a taxpayer applied the safe harbor election.
The implication of the withdrawal is that nonrefundable milestone payments, creditable to success-based fees, are not themselves success-based fees, and are therefore not covered by Revenue Procedure 2011-29. As LB&I directives were never reliance guidance, it remains to be seen whether IRS agents will consistently apply the effective date or look back to years covered under LB&I-04-0114-001 when it was in force. This lends uncertainty as to whether taxpayers should carefully consider how this obsoleted guidance affects their treatment of transaction costs.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP (United States), National Tax – Accounting Periods, Methods, and Credits
Ernst & Young LLP (United States), International Tax and Transaction Services