January 10, 2007
Mr. Lewis J. Fernandez
Associate Chief Counsel, Income Tax and Accounting
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, DC20044
Re: Documentation Requirement Under Reg. Section 1.263(a)-5(f)
Dear Mr. Fernandez:
Enclosed are comments prepared by the American Institute of Certified Public Accountants (AICPA) regarding the documentation requirement under reg. section 1.263(a)-5(f). These comments were developed by the Success-Based Fees Task Force of the AICPA’s Tax Accounting Technical Resource Panel and approved by the Tax Executive Committee.
Based on recent examination experience, the IRS is taking the view that timesheets are the only acceptable form of documentation to support an allocation of an investment banker’s success-based fee between deductible and non-deductible expenses. This position is clearly inconsistent with the stated intent of IRS and Treasury in issuing reg. section 1.263(a)-5(f), thereby effectively rendering the regulations moot.
Therefore, the AICPA recommends that the IRS and Treasury consider issuing a ruling or a revenue procedure that would clarify how this regulation should be applied, and set forth safe harbor provisions to give taxpayers certainty when allocating success-based fees. Such guidance would significantly reduce controversy in this area, thereby freeing up both IRS and taxpayer resources.
We appreciate your consideration of these comments. If you have any questions, please contact me at ; Christine Turgeon, Chair, AICPA Tax Accounting Technical Resource Panel, at ; or George White, AICPA Technical Manager, at .
Sincerely,
Jeffrey R. Hoops
Chair, AICPA Tax Executive Committee
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
Comments on Documentation Requirement
Under Reg. Section 1.263(a)-5(f)
Developed by the
Success-Based Fees Task Force
Jennifer D. Kennedy, Chair
William B. Creps
Kimberly A. Harrington
Louis J. Miller
George White, AICPA Technical Manager
January 10, 2007
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
Comments on
Documentation Requirement Under Reg. Section 1.263(a)-5(f)
EXECUTIVE SUMMARY
In reg. section 1.263(a)-5(a), the fees paid to investment bankers are typically the single largest fee a taxpayer may incur in the course of the transaction. These fees – typically payable only on the successful completion of the transaction – have generated a significant amount of controversy in IRS examinations.
Regulation section 1.263(a)-5(f) allows taxpayers to allocate fees among the deductible and non-deductible services rendered by the investment banker, if sufficient documentation supports the allocation. Regulation section 1.263(a)-5 generally provides that a taxpayer must capitalize amounts paid to facilitate certain specified transactions. In the case of certain covered transactions (including certain M&A type transactions), however, an amount is deemed to facilitate the transaction only if the amount relates to activities performed on or after the “bright-line date,” unless such activity is considered an inherently facilitative activity, in which case the amount is capitalized regardless of when the activity was performed relative to the bright-line date. Therefore, any amounts paid for activities performed in the process of investigating or otherwise pursuing a transaction that occur before the “bright-line” date are generally deductible for tax purposes.
For purposes of paragraph (f), documentation must consist of more than merely an allocation between the activities that facilitate the transaction and activities that do not facilitate the transaction, and must consist of supporting records (for example, time records, itemized invoices, or other records) that identify:
- The various activities performed by the service provider;
- The amount of the fee (or percentage of time) that is allocable to each of the various activities performed;
- Where the date the activity was performed is relevant to understanding whether the activity facilitated the transaction, the amount of the fee (or percentage of time) that is allocable to the performance of that activity before and after the relevant date; and
- The name, business address, and business telephone number of the service provider.
Although courts have long-acknowledged a taxpayer’s ability to allocate lump-sum or success-based fees,[1] wording of reg. section 1.263(a)-5(f) evidences the intent to give taxpayers flexibility in meeting the documentation requirement. Specifically, the regulations reference time records and invoices as examples along with “other records.” By definition, a document that contains each of the four elements set forth in reg. section 1.263(a)-5(f) is a “supporting record” within the meaning and spirit of the regulation.
However, recent taxpayer experience in transactions occurring subsequent to the effective date of this regulation has been fairly consistent at the examination level. The Service has taken the position that no allocation of a success-based fee should be permitted, and thus, the entire fee must be capitalized, if the investment banker does not provide to the taxpayer timesheets detailing the services provided and when such services were provided.
This view is inconsistent with the final regulations. Although timesheets are an acceptable form of documentation, they are not the exclusive form of acceptable documentation under reg. section 1.263(a)-5(f). As discussed in greater detail below, the investment banking community, as a general practice, has consistently stated that it does not maintain detailed time records nor do they provide detailed invoices to describe the services rendered. Consequently, taxpayers are unable to provide such information to IRS examiners.
A review of the history of reg. section 1.263(a)-5, shows the IRS and Treasury’s intent to provide taxpayers flexibility in satisfying the documentation requirement; not to promulgate a standard that no taxpayer could meet.
ADVANCE NOTICE OF PROPOSED RULEMAKING
On January 17, 2002, Treasury and IRS issued an advance notice of proposed rulemaking (Notice) and a press release quoting then-Treasury Assistant Secretary (Tax Policy) Mark Weinberger as saying:
Currently, the IRS spends a substantial and disproportionate amount of its examination resources resolving capitalization issues. Recently, much of the uncertainty and controversy in the capitalization area has related to expenditures that create or enhance intangible assets. We believe the rules and principles described in this advance notice with respect to intangible assets are a first step to providing clear and administrable rules that will significantly reduce uncertainty and controversy in this area, thereby freeing up both IRS and taxpayer resources.
PROPOSED REGULATIONS
On December 18, 2002, Treasury and IRS issued proposed regulations under section 263(a) regarding the capitalization of costs incurred with respect to intangible assets. Echoing her predecessor, then Treasury Assistant Secretary (Tax Policy) Pam Olson stated:
Uncertainty regarding the proper treatment of amounts spent that result in intangible assets has caused significant controversy between taxpayers and the IRS in recent years…The proposed regulations are an important step to clear and administrable rules that will allow taxpayers to compute their tax liability properly and the IRS to administer the law efficiently and fairly. The rules in the proposed regulations will reduce uncertainty and controversy in this area, freeing up both IRS and taxpayer resources for more productive activities.
In explaining the rule in prop. reg. section 1.263(a)-4(e)(4)(i)(C) requiring capitalization of success-based fees paid to facilitate an acquisition unless evidence clearly demonstrates that some portion of the fee can be allocated to activities that do not facilitate the acquisition, the preamble to the proposed regulations explained:
The proposed regulations provide that a success-based fee is an amount paid to facilitate the acquisition except to the extent that evidence clearly demonstrates that some portion of the amount is allocable to activities that do not facilitate the acquisition. . . The IRS and Treasury Department stress that section 6001 of the Code requires taxpayers to maintain sufficient records to support a position claimed on the taxpayer’s return. Thus, taxpayers must maintain records adequate to document that amounts relate to activities performed prior to the bright line date.[2]
Proposed reg. section 1.263(a)-4(e)(7), Example 9, involves fees paid to an investment banker providing a variety of services, including due diligence on the targets, determining the value of prospective targets, negotiating and structuring the transaction with a target, drafting the merger agreement, securing shareholder approvals, preparing SEC filings, and obtaining the necessary regulatory approvals. This example concludes that the portion of the fees paid to the investment banker to conduct due diligence prior to the date of the letter of intent (i.e., the bright-line decision date) is deductible. Notably, this example does not state that the taxpayer obtained from the investment banker time reports that documented and substantiated the deductible due diligence services provided by the investment banker.
During the comment period on the proposed regulations, a number of interested parties addressed the documentation requirements associated with success-based fees and the types of documentation typically available from investment bankers, including the following:
Deloitte & Touche LLP; March 19, 2003:
[I]t is well recognized that investment bankers do not maintain detailed time records of the work related to the services they have performed, whereas attorneys and accountants generally do.
PricewaterhouseCoopers LLP; April 22, 2003:
The regulations should contain language acknowledging that the types of records maintained by both service providers and taxpayers vary widely (e.g., time records are not available for investment bankers and certain other financial advisors, so they may make a reasonable allocation of their effort per the “Cohan Rule”). In addition, the language in the final regulations should include a statement indicating that the adequacy of documentation supporting the deductibility of transaction costs will vary based on the facts and circumstances surrounding the transaction. However, such documentation, if reasonable, should be accepted for purposes of demonstrating that some portion of the fees is allocable to services that did not facilitate the transaction.
Various types of records are available in the context of a transaction. For example, in an acquisition transaction, these records may include dated presentations from external service providers to demonstrate the types of services that were rendered; transaction timelines that provide the dates of various meetings and demonstrate activities performed by service providers prior to a final decision date; internal memoranda regarding the transaction; Board of Directors' meeting minutes discussing service provider activities and the status of the decision process to proceed with the transaction; and detailed invoices. However, the available documentation may vary widely from transaction to transaction, depending on the service providers involved, the size of the transaction, and the type of companies involved. For example, a public company likely will create a transaction timeline for use in its SEC filings, while a private company is less likely to maintain such a document because no publicly disclosed filings are required. Similarly, the type of documentation provided by the external service providers also varies.
American Bar Association; April 25, 2003:
The Proposed Regulations require capitalization of success based fees unless the evidence “clearly demonstrates” that such fees do not facilitate the acquisition. It is not clear how such a rule would be applied. Success based fees are the norm in almost every acquisition transaction. Accordingly, an example describing typical transactions with success based fees and when such fees would and would not be deductible would be very helpful in avoiding future disputes regarding application of this rule.
One important example of a typical transaction is as follows: An investment banker agrees to perform services that include becoming familiar with the business operations, financial condition, prospects and management of the client, advising and assisting management and the Board of Directors of the client in evaluating an acquisition proposal or alternative proposals, providing financial advice in connection with the acquisition proposal or alternative proposals, assisting in negotiating and structuring the terms of and implementing one of the proposals, and rendering a fairness opinion. The banker maintains no time records. Payment for the services is conditioned upon the closing of an acquisition or one of the alternative proposals.
From these and other comments, Treasury and the IRS were made aware that investment bankers do not maintain time reports detailing the services they provide. Hence, it appears that the phrase “other records” in reg. section 1.263(a)-5(f) was intended in part to allow taxpayers flexibility in the types of records that could be produced to evidence activities performed by investment bankers.
FINAL REGULATIONS
On December 22, 2003, Treasury and IRS finalized the proposed regulations under section 263(a). Pamela Olson reiterated the governments’ intention that these regulations once and for all resolve the controversies that have existed regarding the capitalization of intangible assets, stating:
In recent years, controversy regarding the capitalization of costs associated with tangible and intangible assets has consumed substantial IRS and taxpayer resources. . . The final regulations issued today provide clear and administrable rules that will provide certainty to taxpayers regarding the treatment of costs associated with intangible assets and will enable the IRS to fairly and efficiently administer the law.
The final regulations modified several rules regarding success-based fees. First, the final regulations mandated that all documentation supporting the deduction for any portion of a success-based fee must be completed on or before the due date of the taxpayer’s timely filed original federal income tax return for the tax year during which the transaction closes. Second, the final regulations relaxed the documentation requirements necessary to support a deduction and provided examples of the types of documentation needed to substantiate the deduction.
The preamble to the final regulations described the changes to the documentation requirements as follows:
In addition, the final regulations eliminate the “clearly demonstrates” standard in favor of a rule providing that success-based fees facilitate a transaction except to the extent the taxpayer maintains sufficient documentation to establish that a portion of the fee is allocable to activities that do not facilitate the transaction. The regulations require that this documentation consist of more than a mere allocation between activities that facilitate the transaction and activities that do not facilitate the transaction.
Specifically, final reg. section 1.263(a)-5(f) requires that a taxpayer must maintain “sufficient documentation” supporting any portion of an investment banker’s success-based fee that is allocable to activities that do not facilitate a transaction, and such documentation must consist of more than merely an allocation between activities that facilitate the transaction and activities that do not facilitate the transaction, and must consist of supporting records (for example, time records, itemized invoices, or other records ) that identify:
- The various activities performed by the service provider;
- The amount of the fee (or percentage of time) that is allocable to each of the various activities performed;
- Where the date the activity was performed is relevant to understanding whether the activity facilitated the transaction, the amount of the fee (or percentage of time) that is allocable to the performance of that activity before and after the relevant date; and
- The name, business address, and business telephone number of the service provider.
As with the proposed regulations, final reg. section 1.263(a)-5(l) includes several examples, most notably Examples 3, 4 and 16. These examples – like Example 9 in the proposed regulations – involve fees paid to an investment banker resulting in a portion of the fees being deducible. Like Example 9 in the proposed regulations, these examples do not state that the taxpayer obtained time reports from the investment banker that documented and substantiated the services provided by the investment banker, but nonetheless allowed a portion of the banker’s fee to be deducted.
INVESTMENT BANKING PRACTICE
Typically, the single largest fee in a transaction is payable to the investment banker. This fee is often derived based on a percentage of the deal value and is intended to compensate the investment banker for a variety of services, including services that may have been provided well in advance of discussions regarding any specific transaction. Investment bankers have consistently stated that they do not maintain detailed time records, nor do they provide a detailed invoice for services rendered. Rather, the invoice is typically issued upon the successful completion of the transaction is labeled, “For Services Rendered.”
The investment banker may become involved well in advance of the proposed transaction, upon the initial development of a transaction or may be the instigator of the transaction. Generally, the majority of an investment banker’s time and effort occurs before the board of directors approves a transaction.
The investment banker provides in-depth research and analyses on the company, its business, its industry, the company’s earning potential, market value and the financial impact of synergies created by a potential transaction. The investment banker participates in meetings with company personnel and the other parties to the potential transaction.
These efforts result in advice or recommendations to company management regarding whether to pursue the potential transaction. Upon approval by the board of directors to proceed with such a transaction, the investment banker services taper off significantly. Generally, a significant portion of the investment banker’s fee is allocated to activities that occur prior to the bright-line date.
The AICPA is concerned that an interpretation of the reg. section 1.263(a)-5(f) documentation requirement at the examination level imposes a standard on taxpayers that cannot be met. We believe that the IRS and Treasury did not intend to require timesheets as the only acceptable form of documentation to support an allocation of a success-based fee. Given that the investment banking community has consistently stated that it does not maintain detailed time records, the AICPA does not believe that the taxpayer should bear the burden of trying to change a long-standing practice of the investment banking community to meet this requirement. Rather, we believe that the plain language of the final regulations permits taxpayers to support the allocations with “other documentation” so long as such documentation satisfies the criteria outlined in reg. section 1.263(a)-5(f).