TAX EXECUTIVES INSTITUTEM&A Agreements: Trends & Pitfalls and

Preparing for Audits

March 26, 2014

Brian KaufmanCapital One Financial Corporation

McLean, VARick Bailine

Washington, DC

Robert Rizzi

Washington, DC

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TOPICS

1. Treatment of Merger Costs2. Allocation of Compensation Expense3. Testing of Qualified Stock Purchases4. Accounting Methods5. Tax Benefit Sharing6. Tax Indemnities7. Abandonment8. Preparation9. Standard Audit Items

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Topic 1:Costs of the Merger

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Expensing v. Capitalization• Always a major area of uncertainty

– For 2011, IRS report on uncertain tax positions indicated that expensing v. capitalization was one of the three primary UTP issues identified for large corporations

• Others were research credit and 482 transfer pricing• Despite years of regulation and guidance,

capitalization treatment of specific items always raises potential controversy issues

• Uncertainty especially highlighted in compensation related expenses of M&A

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Topic 2:Compensation Expense and Allocation

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Compensation-Related Code Sections – Service Recipient

• Section 83(h); Section 404(a)(5)– Defers service recipient’s compensation deduction until taxable year

“in which or with which ends” the taxable year in which the service provider includes compensation in income

• Section 162; Section 263– Whether, in the acquisition context, a compensation-related

expenditure is deductible as a business expense or must be capitalized as purchase price

– Related amount realized and deductibility issues for seller• Section 381(c)(16)

– Acquiror “steps in the shoes” with respect to service recipient’s compensation deduction in certain transactions.

• Section 461– Deductions allowed in accordance with taxpayer’s method of

accounting (accrual vs. cash)– Accrued deductions allowed as economic performance with respect to

item has occurred

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Cash-Out of Equity Awards• Individual A is an employee of Target. As part of Individual A’s compensation

for 2012, Target grants Individual A nonqualified stock options with an exercise price of $3/share

– No ability to make Section 83(b) election with respect to nonqualified stock options

• In 2013, Purchaser acquires 100% of Target’s stock for $10/share in cash. In the acquisition, Target redeems Individual A’s options for $7/share

– Individual A has $7/share of ordinary income – Capitalization vs. Deduction?

• What if vesting with respect to some options is accelerated in connection with acquisition?

• What about the incremental value attributable to deal premium?

Authorities: Section 162; Treas. Reg. Sec. 1.83-6(a)(3); Rev. Rul. 2003-98; Rev. Rul. 73-146; United States v. Gilmore, 372 U.S. 39 (1963);TAM 9438001 (Apr. 21, 1994); TAM 9540003 (Jun. 30, 1995); Treas. Reg. Sec. 1.263(a)-5(d)(1); Treas. Reg. Sec. 1.263(a)-5(l), Ex. 7.

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Allocation of Compensation Expense from Option Exercise

• Key question: Is deduction “owned” in the target’s pre-closing tax year or in acquiring Corporation’s post closing tax year?

• Economically, is compensation/option expense “paid” by target or by acquiring Corporation?• If allocated to pre-closing tax year, will reduce tax liability

and could offset indemnified tax items of target

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Consolidated Return Timing Issues (Same Day and Next Day Rule)

• Treas. Reg. Sec. 1502-76(b)(1)(ii)(A)(1) (the “same day” rule): If a consolidated subsidiary (S) becomes or ceases to be a member during the taxable year, the subsidiary “becomes or ceases to be a member at the end of the day on which its status as a member changes, and its tax year ends for all Federal income tax purposes at the end of that day.”

• Treas. Reg. Sec. 1.1502-76(b)(1)(ii)(B) (the “next day” rule): If, on the day of S’s change in status, a transaction occurs that is “properly allocable” to the portion of S’s day after the event resulting in the change, S and all related persons “must treat the transaction as occurring at the beginning of the following day”– Determination as to whether properly allocable “will be respected if it is

reasonable and consistently applied”– Factors relevant to reasonableness include:

• If the item is from a transaction with respect to S stock, whether it reflects ownership of the stock after the fact

• Whether the allocation is consistent with other requirements of the Code and regulations

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Consolidated Return Timing Issues (Ratable Allocation)

• Treas. Reg. Sec. 1.1502-76(b)(2)(ii)(A) (ratable allocation election): Although the periods ending and beginning with S’s change in status are separate taxable years, “items (other than extraordinary items) may be ratably allocated between the periods” if certain conditions are met

• Treas. Reg. Sec. 1.1502-76(b)(2)(ii)(C)(9) (compensation deduction extraordinary item): Extraordinary items include “any compensation-related deduction in connection with S’s change in status (including, for example, deductions from bonus, severance and option cancellation payments made in connection with S’s change in status)”

• Treas. Reg. Sec. 1.1502-76(b)(2)(ii)(B)(2): “Under ratable allocation, the items to be allocated and their timing, location, character and source are generally determined by treating the original year as a single tax year and the items are not subject to the rules of the Internal Revenue Code applicable to short years … .”

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Cash Out of Stock Options –Consolidated Return

• Parent owns 100% of Target • Parent and Target file a consolidated return • Target has issued nonqualified stock options to employees • Purchaser acquires 100% of Target stock on March 31, 2008. On that date and as

part of the acquisition, Target redeems outstanding employee stock options • Purchaser and Target thereafter file consolidated return

– Ordinary income to option holders – Who gets the compensation deduction (Parent Group vs. Purchaser Group)?

• Same day vs. Next day• Ratable allocation: compensation deduction extraordinary item – may not be

allocated– What if vesting with respect to some options is accelerated in connection with

acquisition?

Authorities: Treas. Reg. Sec. 1.83-6(a)(3); Rev. Rul. 2003-98; Treas. Reg. Sec. 1502-76(b)(1)(ii)(A) (same day rule); Treas. Reg. Sec.1502-76(b)(1)(ii)(B) (next day rule); Treas. Reg. Sec. 1.1502-76(b)(2)(ii)(A)-(B) (ratable allocation method); Treas. Reg. Sec. 1.1502-76(b)(2)(ii)(C)(9) (compensation deduction “extraordinary item”); Treas. Reg. Sec. 1.1502-11(b) (circular basis adjustments); Section 382(h)

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Cash Out of Restricted Stock –Consolidated Return

• Parent owns 100% of Target, which has a December 31 taxable year

• Parent and Target file a consolidated return • Target has issued restricted stock to employees

– Assume no Section 83(b) election • Purchaser acquires 100% of Target stock on

March 31, 2014. On that date and as part of the acquisition, Target redeems outstanding restricted stock

• Purchaser and Target thereafter file consolidated return

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Cash Out of Restricted Stock –Consolidated Return (cont’d)

• Who gets the compensation deduction (Parent Group vs. Purchaser Group)?

No ratable allocation election • Section 83(h) – de facto “next day” rule?

– Ratable allocation election • Compensation deduction extraordinary item – may not be allocated• What if parties agree to treat deduction as a “same day” deduction?

– Treas. Reg. Sec. 1.1502-76(b)(ii)(B)(2) provides that T’s short year is treated as a single twelve-month year “and [T’s short year items] are not subject to the rules of the [Code] applicable to short periods … .”

– Application of Section 83(h)?• What if parties agree to treat deduction as a “next day” deduction?

Authorities: Section 83(h); Treas. Reg. Sec. 1502-76(b)(1)(ii)(A) (same day rule); Treas. Reg. Sec.1.1502-76(b)(1)(ii)(B) (next day rule); Treas. Reg. Sec. 1.1502-76(b)(2)(ii)(A)-(B) (ratable allocation method); Treas. Reg. Sec. 1.1502-76(b)(2)(ii)(C)(9) (compensation deduction “extraordinary item”); Treas. Reg. Sec. 1.1502-11(b) (circular basis adjustments)

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Documentation and Audit Questions

• What language in deal documentation will support allocation of compensation expense?– “parties agree to allocate all expenses related to

payment of options to target Corporation for pre-closing tax years and to file all tax returns consistent there with”

• Why doesn’t the contract control the allocation?• What happens if allocation is challenged?

– What impact does tax indemnity have on allocation of compensation expense?

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Capitalization in Asset Acquisitions: The Common Theme …

• “In the precedent requiring the buyer to capitalize, rather than deduct, the payment of an obligation, the events most crucial to creation of the obligation occur before the acquisition. Under these circumstances, the obligation is treated as a liability of the seller. By contrast, in cases allowing the buyer to take a deduction, the events most crucial to creation of the obligation occur after the acquisition. Under these circumstances, the obligation is a liability of the buyer. The difference in the cases is therefore the degree to which the obligation was fixed at the time of the acquisition” PLR 9721002 (emphasis supplied).

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Assumption of Severance Obligations

• Target has established a severance plan pursuant to which employees are entitled, upon involuntary termination of employment, to a cash payment. The amount of the payment is based on the employee’s length of service with Target

• Purchaser acquires Target’s assets, subject to all related liabilities, including Target’s obligations under the severance plan

Authorities: Rev. Rul. 67-408; Albany Car Wheel Company v. Comm’r, 40 T.C. 831 (1963), aff’d per curiam 333 F.2d 653 (2d. Cir 1964); TAM 9721002 (Jan. 24, 1997), TAM 9731001 (Jan. 31, 1997); Treas. Reg. Sec. 1.263(a)-5(l), Ex. 6.

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Assumption of Pension Obligations• Target has established a pension plan under which employees are entitled,

upon retirement, to annual cash payments based on length of service with Target

• Purchaser acquires Target’s assets, subject to all related liabilities, including Target’s obligations under the pension plan

• At the time of acquisition, Purchaser assumes (i) $500 of unfunded pension obligations attributable to existing retirees and (ii) agrees to maintain pension plan post-closing and to make contributions taking into account employees’ pre-closing employment

Authorities: Webb v. Comm’r, 77 T.C. 1134, aff’d 708 F.2d 1254 (7th Cir. 1983); Buten & Sons v. Comm’r, T.C. Memo 1972-44; GCM 39274 (Aug. 16, 1984); TAM 8436002 (Dec. 16, 1983); TAM 8411106 (Aug. 16, 1984)

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Assumption of Obligation to Pay Deferred Compensation

• Target has established a deferred compensation plan under which high level executives have elected to defer compensation with respect to prior taxable years– Assume no constructive receipt, economic benefit, Section 409A

• Purchaser desires to acquire Target’s assets, subject to all related liabilities, including Target’s obligations under the deferred compensation plan – Amount realized, but deduction deferred under Section 404(a)(5)

• Acquisition agreement should include information exchange covenant so that Seller receives information post-closing upon which to claim compensation deduction

– What if Target liquidates after the acquisition (see e.g. Rev. Rul. 69-6 transaction).

Authorities: Section 404(a)(5); Treasury Regulations Section 1.461-4(d)(2)(iii)(A); TAM 8939002 (Jun. 15, 1989); cf. Pacific Transport Co. v. Comm’r, 483 F.2d 709 (9th Cir. 1973)

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Buyout-Related Retention Arrangements

• Target and Employee enter into an employment agreement that provides that if Target is acquired, Employee will be entitled, three years after the acquisition, to receive a cash payment of $1,000,00

• Employee’s rights to a post-closing payment terminate if Employee ceases to be employed by Target or buyer on the three-year anniversary of a change-in-control

• Purchaser acquires all of Target’s assets, including it liabilities and obligations to pay Employee pursuant to the terms of Employee’s employment agreement

• Employee remains employed for three years and receives a cash payment from purchaser – What if employment agreement is put in place shortly before, and in

anticipation of, acquisition and Employee is required to work only 6 months for Purchaser?

Authorities: FSA 200148006 (July 30, 2001); Treas. Reg. Sec. 1.263(a)-5(d)(1); Great Lakes Pipe Line Co. v. U.S., 352 F.Supp 1159 (W.D. Mo. 1973)

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Revenue Ruling 2003-98• Facts: On January 1, 2003, Employee, an employee of Company M, is

granted options to purchase shares of M common stock (the “M Option”). M has a September 30 taxable year. On November 15, 2006:

– Situation 1: N acquires the stock of M for cash, and N continues to hold M as a wholly owned subsidiary. On the acquisition date, the M Option is exchanged for options in N (the “N Option”). On January 15, 2007, Employee exercises the N Option. N’s taxable year also ends September 30.

– Situation 2: Same as Situation 1, but N cashes out Employee’s N Option on January 15, 2007

– Situation 3: Same as 1, but the M Option remains outstanding and is cashed out by N on January 15, 2007

– Situation 4: Same as 1, but on November 15, 2006 M merges into N in a Section 332 liquidation

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Revenue Ruling 2003-98 (cont’d)

• Option Substitution: Not taxable; in each case, Employee has taxable compensation income only upon option exercise/cash out

• Deduction: “[B]ecause M is the service recipient with respect to either the M Option or the N Option, M, and only M, may claim the compensation deduction.” (emphasis supplied)– Treas. Reg. Sec. 1.83-6(a)(1)

• Shareholder Capital Contribution: N is treated as making a cash capital contribution to M in Situations 1, 2, 3– Deemed cash purchase model (Treas. Reg. Sec. 1.1032-3)

• “Step in the Shoes”: In Situation 4, Section 381 applies to the Section 332 liquidation; N succeeds to M’s compensation deduction– Section 381(c)(16)

• Year of Deduction: Taxable year ending September 30, 2007– Cash equals “substantially vested property” for purposes of

Treas. Reg. Sec. 1.83-6(a)(3); thus, Section 83(h) does not apply and deduction allowed under M/N’s regular method of accounting

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Revenue Ruling 2002-1• D owns 100% of the stock of C

– A is an employee of D; B is an employee of C• In Year 1, D issues restricted D stock and D options to A and, “on behalf of

C”, B.– No Section 83(b) election by either A or B with respect to restricted

stock• In Year 3, D distributes C pro rata to shareholders in a transaction

qualifying under Section 355• In the spin-off:

– A and B receive restricted C stock “in order to preserve their pre-spin economic interest in pre-spin-off restricted D stock”

– Pre-spin options are cancelled and replaced with new D and C options “designed to preserve the economic terms of” pre-spin options

• In Year 6, restrictions lapse on all restricted stock and A and B exercise all post-spin options

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Revenue Ruling 2002-1

• IRS addressed tax consequences of equity compensation spin-off using time “freeze”/retrospective framework – Following spin-off, neither Distributing nor Controlled will recognize

gain or loss when employees receive stock compensation -- in other words, no zero basis problem

– Corporation that originally issued compensatory options/stock entitled to Section 162/83(h) deductions

• Thus, where employees hold both Distributing and Controlled equity following spin-off, deduction “relates back” to when compensation plan entered into and at date of spin-off – Query: What if employees work for both Distributing and Controlled,

or both at different times?

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Consequences of Stock-Based Compensation Where the Issuer is not Current Employer

D

C

Shareholders

A

B

*

*

* D restricted stock and stock options

Base Case

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Revenue Ruling 2002-1 (cont’d)

• Ruling notes that particular executive compensation plan was not adopted in anticipation of a spin-off

• Post spin-off, employees each held restricted stock and options in both the Spinnor and the Spinnee– In many such transactions, employees of the Spinnee who

previously held Spinnor options may give up those options and instead receive solely Spinnee options that are adjusted for the economic 'spread' that was imbedded in the Spinnor options previously held

• Retrospective analysis: Spinnor employee who participated in plan had 'valuable economic rights' with respect to both the Spinnor stock and, indirectly, stock in the Spinnee.

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Revenue Ruling 2002-1 – Corporate Consequences (cont’d)

Base Case• Do either D or C recognize gain or loss when the employees

receive the stock compensation? • Which corporation is entitled to the compensation deductions? • How do the transactions involving stock to B affect D’s basis in

its C stock? See Treas. Reg. Sec. 1.83-6(d)

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Revenue Ruling 2002-1 Variations –Mix of Distributing and Controlled

Equity

D

C

Shareholders

A

B

Before

*

*

D C

Shareholders

A B*

After

* Only D restricted stock and options (i.e., no C equity) * Separated D and C restricted stock and stock options

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Topic 3:Challenges to Qualified Stock

Purchases

Sale to a Related Party

• Partnership (PS) wants to purchase S Corporation and make section 338(h)(10) Election.

• PS forms Holdco (HC)• Holdco Forms Acquiring Corp (Acq.)• Acq. buys 100% of S Corp from A, B, and

others. A and B each own 15% of S Corp.• A and B invest portion of proceeds in PS.

Together they own 5% of PS.

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Sale to a Related Party

• Section 338(h)(3)(A)(iii)—Purchase

• Section 318(a)(3)—Attribution to Partnership

• Treas. Reg. 1.338-3(b)(3)(ii)(A) or (B) v. (C)—time to test relationship

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Topic 4:Changes of Accounting Method

Following Merger

Changes in Accounting Method• Application of Section 381(a)

– If the acquiring corporation continues to operate a trade or businesses of the acquired corporation as a separate and distinct trade or businesses, the acquiring corporation must use a carryover method (i.e., the overall method of accounting used by each party for each separate and distinct trade or business prior to the date of the transaction)

– If the trade or business of the parties to the transaction are not operated as separate and distinct trades or businesses after the date of distribution or transfer, then the acquiring corporation must use its existing method as the principal method (unless the target’s method is “greater” than the acquirer’s under Treas. Reg. §1.381(c)(4)-1(c)(1))

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Changes in Accounting Method• The acquiring corporation does not have to obtain the IRS’s

consent either to continue the carryover method or to use the principal method. However, any change to a principal method, whether the change relates to a trade or business of the acquiring corporation or a trade or business of the acquired corporation, must be reflected on the acquiring corporation’s tax return for the tax year that includes the date of the transaction.

• The above rules do not apply if the carryover method, or the principal method, as applicable, is not a permissible method, or if the acquiring corporation chooses not to use a carryover method or a principal method. In such cases, the general rules governing changes of method of accounting apply.

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Topic 5:Tax Benefit Sharing

Increasing Interest in Sharing Tax Benefit of Transaction Expenses

• If options are counted as equity acquired by Acquiror, Target shareholders have claim to tax benefits from option expense used by Acquiror

• Tax benefit provisions require Acquiror to compute tax benefit and to pay Target shareholders additional purchase price

• If acquisition results in basis step up, additional amortization benefit to be allocated

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Topic 6:Tax Indemnity Calculations

Tax Indemnity Issues

• Typical tax indemnity provision requires indemnifying party to reimburse indemnified party for incremental tax cost– Is tax gross-up applied to indemnification

payments?– How is incremental tax cost computed?

• Is indemnified tax cost computed from loss deductions first dollar or last dollar?

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Example of Tax Indemnity

• Target has undisclosed SALT tax liability of $100, which is paid by acquirer; under merger agreement, Acquiror claims indemnity of $100

• Acquiror payment of $100 generates federal tax benefit of $40

• Indemnity payment generates $40 of additional federal tax; gross up to net $100 is approx. $165 (165 * .40 = 66; 165 - 66 = $100 net cash)

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Topic 7:Abandonment

Abandonment

• IRS has been aggressive in addressing abandonment deductions related to Corporate transactions.

• Plan to do IPO nixed for poor market conditions

• Two years later IPO complete: are costs associated with first IPO plan deductible or do they facilitate completed IPO?

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Abandonment

• IRS focus is on decision to do IPO

• Because IPO in best interest of Corporation that notion is not abandoned

• But is the original “plan” abandoned; changes in shareholders, pricing, shares, regulatory scheme etc.

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Topic 8:Document Preparation

Document Preparation

• Contemporaneous v. current• Privileged or non-privileged• Level of Authority—Economic Substance• Focus IDR Program—Response time

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Topic 9:Standard Audit Items

Standard Audit Items

• Purchase Accounting Review—Book/Tax Differences

• Deductibility of Deal-Related Expenses • Change in Control/Parachute Payments—

Section 280G• Section 382 Limitations

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