FEDERAL
Relief Is on the Horizon: A Look at Transaction Costs Related to Acquisitions and Business Integration

In a challenging economy, making every dollar count is part of the corporate DNA. At most companies strategic tax planning plays an important role in achieving that goal. One area that is particularly scrutinized is the tax treatment of transaction costs related to acquisitions and business integration.

For the past decade or so, this has been a virtual minefield from a tax-planning perspective. While businesses have been intent on flowing every allowable dollar to the bottom line, the Internal Revenue Service has set its sights on maximizing revenue related to the tax treatment of M&A expenses.

The Recent Stance of the IRS
The IRS’s aggressive stance dates to a 1992 Supreme Court case, INDOPCO, Inc. v. Commissioner, 503 US 79 (1992). It has used this case as the basis to argue that most costs associated with acquisitions, business combinations, business integrations and the protection, development or enhancement of an intangible asset must be capitalized if there is a possibility that a future benefit will result from the outlay.

Other issues include the treatment of investigatory and due diligence costs, expenses related to defending against hostile takeover attempts, the deduction of business start-up costs, and the treatment of facilitative costs—all of which have been the subject of numerous court cases.

Understanding Transaction Costs
Generally, case law segregates transaction costs into two classes: investigatory, which are either immediately deductible or amortized over 60 months, and facilitative, which are nondeductible.

Specific transaction costs vary depending on whether a corporation is the acquirer or the target and whether the takeover is hostile or friendly. They can include investment banking, legal and accounting fees (i.e., due diligence expenses, fairness opinion); salaries and wages of employees; bonuses; severance payments; stock option and stock appreciation rights; and regulatory costs (i.e., SEC, Hart Scott Rodino, maintenance of existing licenses).

The INDOPCO Coalition’s Fight for Tax Relief
The question of whether to deduct or capitalize an expense has been one of the most nettlesome for corporate taxpayers in the “INDOPCO Era” (as some have termed it), but relief may be on the horizon. The INDOPCO Coalition, a group consisting of representatives of many leading corporations and tax-law luminaries, such as former IRS Commissioner Fred Goldberg, has been fighting to reverse the IRS’s basic presumption on capitalization. It appears the Coalition may have achieved some success.

The Internal Revenue Service recently issued final regulations on the capitalization of amounts paid to acquire, create or enhance intangible assets. Some of them cover taxable and tax-free acquisitions and dispositions, restructurings, redemptions and other types of capital transactions.

IRS Shifts Its Position with Recently Issued “Final” Regulations
Final regulations issued on December 22, 2003 still require capitalization of transaction costs that facilitate the acquisition, creation or enhancement of an intangible asset, or that facilitate a restructuring or reorganization of a business entity or a transaction involving the acquisition of capital (e.g., stock issuance, recapitalization). However, they abandon the “whether-and-which” test of Revenue Ruling 99-23, which required taxpayers to conduct an often difficult analysis to distinguish the costs of investigating an acquisition (generally deductible/amortizable) from the costs of facilitating it (which must be capitalized). If an expense was related to “whether” to acquire a business or “which” business to acquire, it was investigatory and deductible. However, once those decisions had been made, the expenses became facilitative and non-deductible from that point on—even if they are for exactly the same services or types of services.

Replacing that quagmire in the final regulations is a bright-line test requiring capitalization of only those costs that facilitate an acquisition (defined as the amount paid in the process of investigating or otherwise pursuing the transaction). As a result, an amount is not treated as facilitating the creation of a contract right if the amount relates to activities performed before the earlier of the date the taxpayer begins its bid for the contract or the date the taxpayer begins discussing or negotiating the contract with another party to the contract. Moreover, all costs relating to certain acquisitive transactions incurred prior to reaching a preliminary agreement (usually signaled by a letter of intent or board approval of an acquisition proposal) are no longer required to be capitalized.

The final regulations also narrow the standard for determining which transaction costs inherently facilitate an acquisition and so must be capitalized. For example, the cost of downsizing a workforce following an acquisition had to be capitalized under the previous standard, but would be deductible under the new one. Likewise, the cost of defending against a hostile takeover would not have to be capitalized.

These regulations represent a vast improvement over the current guidelines. The final rules reflect a substantial shift in the IRS’s position regarding the tax treatment of transaction costs related to acquisitions and business integration and therefore signal welcome relief for corporate taxpayers

STATE & LOCAL
“Economic Nexus” Reemerges as Cash Strapped States Weigh in

With budget coffers close to running on empty for many state and local governments, taxpayers can expect to see an increasing amount of attention paid to the issue of “economic nexus” in the months ahead.

The legal concept of nexus determines whether a business has enough of a presence in a state or locality to become subject to its business activity taxes (BATs). In the context of sales tax, it refers to the extent of physical presence in a state that triggers a company’s tax-collection responsibility.

Since 1959, when Congress enacted Public Law 86-272, the nexus rule of thumb has been that companies are not liable for sales tax collection in states where their only business activity is sales solicitation for tangible personal goods, nor are they subject to a state’s BATs under those circumstances. From the states’ point of view, however, nexus has always been a fluid concept, and a number of revenue-hungry states are trying to advance the idea of economic nexus.

Defining Physical Presence
At its core, the concept of economic nexus holds that tax nexus exists whenever a business has derived revenue or income from a customer in a state, even if the business has no property, employees or other significant physical presence in that state. That concept flies in the face of case law that has guided decisions in this area, starting with the 1992 U.S. Supreme Court decision in Quill v. North Dakota, 504 US 298(1992).

The Quill decision established a requirement that a company must have more than a minimal physical presence in a state before that state can require the company to collect its sales taxes. Although the U.S. Supreme Court has yet to rule on BATs, several state courts have since ruled that the Quill physical-presence doctrine does apply to BATs, which undercuts any argument for economic nexus.

JC Penney (JC Penney Nat’l Bank v. Johnson, 19 S.W.3rd 831, Tenn. Ct. App. 1999) and America Online (America Online, Inc. v. Johnson, Tenn. Ct. of Appeals, May 6, 2002)—neither of which has any substantial physical presence in the state of Tennessee—both have won decisions in that state’s Supreme Court reaffirming the income tax safe harbor standards established by Quill as recently as last year.

Determined States Push Economic Nexus
So, all is well, right? Not quite. Tax experts and business analysts point to New Jersey’s recent enactment of a piece of legislation called the Business Tax Reform Act (BTRA), A.B. 2501 (2002) as alarming evidence that cash-strapped states are determined to find a way around the constitutional issues and case law that have so far served as roadblocks to their attempts to assert economic nexus. What’s more, if New Jersey is successful in its attempt, other states are likely to follow suit.

New Jersey’s push to extend its tax-levying authority to new levels has triggered heated response. “Rarely has a state legislature paid less heed to constitutional constraints,” is how one critic put it in an article in State Tax Notes, a trade journal. “There is no question that many of the BTRA’s provisions will give rise to litigation and, given the tenuous legal bases for some of the provisions, also likely be declared unconstitutional.”

New Jersey corporation business (income) tax formerly applied to corporations doing business, employing or owning capital property, or maintaining an office in New Jersey. With the revision of the business (income) tax law, now New Jersey extends its taxation to corporations deriving receipts from sources within New Jersey or engaging in contacts within the state.

An economic nexus initiative by the Connecticut legislature in August was beaten back by intense lobbying, but similar efforts are underway in Georgia, Florida, Minnesota and possibly other states, according to the Investment Company Institute.

A Solution
The best solution would be the adoption of bright-line standards that remove the ambiguity around substantial nexus, suggests the Institute for Policy Innovation, a non-profit public policy think tank founded by Congressman Dick Armey. Because the issues involved derive from the Commerce Clause, the U.S. Supreme Court ultimately will have to rule on whether those standards fit within the confines of this Clause.

INDIVIDUAL
Pre-Paid Tuition: Introducing the Independent 529 Plan

Anyone facing the prospect of paying for a college education at some point in the future is likely aware that tuition and related costs have been on the rise. What comes as a shock to many, however, is just how dramatic those increases have been. College costs have consistently increased at about twice the rate of inflation, according to FinAid (www.finaid.org), and at times the rate of increase has been even steeper.

According to the College Board, average costs for the 2002-2003 school year were $27,677 for students attending private colleges and universities, $19,188 for out-of-state residents attending public institutions and $12,841 for students attending public colleges and universities in their home states. However, as any parent of a college student can attest, actual out-of-pocket expenses are usually more than the published averages, thanks to travel costs, cell phones, computers, clothing budgets, spending money, etc.

Of course, costs are highest at the top schools. The “sticker price” for the current year at Brown University, for example, is $40,278; Stanford will run you $39,967, while Harvard looks to be a relative bargain at $37,746. And it’s not just the Ivy League that is commanding top dollar. Top echelon schools such as Boston University and Duke have broken the $40,000-a-year barrier or are about to. (Duke, incidentally, wins the dubious honor of having the greatest percentage increase in cost among the Princeton Review’s “Best Colleges” for the period 1960-61 through 2001-02. With a 2,138% increase in total student costs, Duke edged out runner-up U.C. Berkeley, where costs for non-resident students at the state school skyrocketed 2,114%. The total inflation rate for that period was only about 747%.)

Private Colleges Offer Tuition Solution
Coming up with that kind of money can be a challenge for anyone, and a growing number of colleges and universities have come to acknowledge that. To offer parents of future college students one solution to the problem, a nationwide group of private colleges has joined together to sponsor a new prepaid tuition program called the Independent 529 Plan.

The plan lets participants lock in future tuition costs at a level lower than current prices with the purchase of certificates that can be used to pay future tuition costs. It is the first 529 plan sponsored by private colleges, and already there are hundreds of top schools involved in the program—Carnegie Mellon, Franklin & Marshall, Pepperdine, Notre Dame, Wake Forest, Vanderbilt and Princeton, to name a few.

Independent 529 Plan Benefits
Benefits of the program include freedom from investment risk, tuition inflation and federal taxes, subject to certain conditions. For example, participants who take a refund rather than redeem a certificate for its intended purpose will have the refund adjusted based on the net performance of the program trust, subject to a maximum return of 2% per annum and a maximum loss of 2% per annum. While there is no upfront tax deduction, qualified withdrawals will not be subject to federal taxes under current law. However, that law is set to expire on December 31, 2010, and Congress may or may not renew it, which could affect the program in the future or even lead to its termination.

In addition to protection against tuition inflation, the Independent 529 Plan provides a certificate discount that lets participants purchase future tuition at less than today’s prices, with the discount rate varying by school, but always at least half a percentage point per year. Like other qualified tuition programs under Section 529 of the Internal Revenue Code, the Independent 529 Plan provides tax-free growth of contributions (assuming qualified withdrawal), and purchases of up to $11,000 per year for one beneficiary ($22,000 for married couples) are free of federal gift tax.

Wealthy individuals looking to reduce their estate can elect to contribute up to $55,000 per beneficiary ($110,000 for married couples), without incurring the federal gift tax. However, the $55,000 contribution is counted against the $11,000 annual gift exclusion over five years. Therefore, these individuals will not be able to make additional tax-free gifts to their children for six years without incurring a gift tax liability.

For more information and a list of participating private colleges and universities, visit the plan’s website at www.independent529plan.org.

The information contained in TaxView is for general purposes only and is not intended, and should not be construed, as legal, accounting, or tax advice or opinion provided by Geller & Company to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs. Therefore, the information should not be used as a substitute for consultation with professional accounting, tax, or other competent advisors.