Takeover Expenses: National Starch and the IRS Add New Wrinkles
In the 1980s, the business world witnessed a proliferation of mergers and acquisitions. Of transactions valued at $1 million or more, over 31,000 M&As involving U.S. companies occurred during the last decade, with a total value exceeding $1.34 trillion. Although the number of M&As appears to be declining, the dollar value of transactions in which public companies are targeted for takeover continues to increase. Given takeovers' volume and magnitude and the tax dollars at stake, the Internal Revenue Service is paying particular attention to takeover-related expenses. For the acquiring company, the rules for the proper tax treatment of M&A costs are reasonably clear--generally the costs are nondeductible capital expenditures. However, because much uncertainty surrounds the tax treatment of the acquired or target company's expenses, careful planning is necessary. This article examines the evolution of tax rules for a target company's costs during a hostile or friendly takeover. Strategies to maximize current deductions also are suggested. (See exhibit 1, page 90, for a summary of the evolution of corporate takeovers. A glossary of takeover terms appears on page 92. ) HOSTILE TAKEOVERS, WHITE KNIGHTS AND RELATED EXPENSES A takeover attempt opposed by the target company's management or board of directors is a hostile or unfriendly takeover. Typically, the acquiring company makes a tender offer to buy shares in the target company from some or all of the latter's shareholders. If the target's board determines a takeover is not in shareholders' best interests, defensive measures generally are taken, possibly including the search for a white knight. The target company incurs expenses to evaluate a tender offer. Directors often retain an investment banking firm to value the stock and issue a fairness opinion. Also, the directors typically retain legal counsel. If the board decides to resist the takeover, it incurs expenses for defensive actions. Exhibit 2, page 93, summarizes this process. The central tax issue is whether the costs of defending against a hostile takeover or facilitating a white knight acquisition are deductible. Under Internal Revenue Code section 162, a deduction is allowed for all ordinary and necessary expenses incurred in carrying on a trade or business. "Ordinary" is not defined in the statutes and is left to judicial interpretation. In Welch v. Helvering [290 US 111 (1933)], the U.S. Supreme Court concluded expenses common to a particular industry or line of business are ordinary. Moreover, such expenses need not be habitual or recurring to be considered common. Thus, an expense occurring only once in the taxpayer's life nevertheless may be an ordinary business expense. The costs of a proxy contest to protect corporate policy, for example, were deductible as ordinary business expenses in Locke Manufacturing Companies v. United States [237 F. Supp. 80 (DC Conn. 1964)]. The district court said proxy contests had become a "standard or norm of conduct" and thus were ordinary. Commissioner v. Tellier [383 US 687 (1966)] further refined the definition of ordinary. In Tellier, the Supreme Court said the principal function of "ordinary" in section 162 is to distinguish between currently deductible expenses and nondeductible capital expenditures. PRE-1989 ADMINISTRATIVE PRONOUNCEMENTS The IRS issued revenue ruling 67-1 to announce it would follow the decision in Locke Manufacturing on deductibility of corporate proxy fight expenditures. However, deductions for such expenses were allowed only if incurred to protect corporate policy. Corporate proxy contest expenditures "primarily for the benefit of the interests of individuals" still were not deductible. The ruling's language suggested the expenditures would be disallowed only if they were preferential dividends to stockholders or excessive compensation to officers-stockholders. A subsequent pronouncement, revenue ruling 67-125, established the "alteration of capital structure" rule, based on the proposition any expenditure related to a change in a corporation's capital structure must be capitalized. …