MEMORANDUM FOR LMSB INDUSTRY DIRECTORS DIRECTOR, FIELD SPECIALISTS FROM: Kathy Petronchak, Director, Pre-Filing and Technical Guidance SUBJECT: Examination of Transaction Costs in the Acquisition of Businesses In an effort to effectively utilize resources, the Large and Midsize Business Division (LMSB) announces a directive that provides Examining Agents with a benchmarking tool to assist them in determining whether to audit the tax treatment of certain transaction costs incurred in connection with a taxpayer’s acquisition (or disposition) of a trade or business. This Directive applies only to the treatment of transaction costs incurred in a merger or acquisition. For this purpose, we are limiting the term “merger or acquisition” to mean a transaction described in §1.263(a)-5(e)(3) of the Treasury Regulations (an "M&A transaction"). This Directive does not apply to the treatment of costs incurred in, among other things, a stock issuance, a stock distribution or other divisive transaction, a stock redemption or reacquisition, or the payment of a dividend or other corporate distribution. Further, this Directive does not apply to the treatment of termination fees incurred by a taxpayer in an M&A transaction. This Directive reflects a management decision to balance resources and workload priorities. This Directive is not an official pronouncement of law, and cannot be used, cited, or relied upon as such. BACKGROUND Much uncertainty and controversy in the capitalization area has been focused on which transaction costs must be capitalized under §263(a) as costs related to the acquisition of a new trade or business and which costs were amortizable as start up costs under §195 or were otherwise deductible under §162(a). This determination is highly fact intensive and the investigation leading to such a determination is extremely time-consuming. Treas. Reg. §1.263(a)-5(e) sought to clarify the proper treatment of costs incurred within the ambit of a business acquisition, drew some bright lines defining inherently facilitative costs, and set some watershed events separating investigative costs from costs facilitating acquisition. Further, that Regulation established recordkeeping requirements which must be met to establish any part of a success based fee as other than a capitalizable cost of acquisition under §263(a). Treas. Reg. §1.263(a)-5 is applicable to amounts paid or incurred on or after December 31, 2003. Where a taxpayer changes its method of accounting to comply with Treas. Reg. §1. 263(a)-5(e), in computing the Section §481 adjustment, Treas. Reg. §1.263(a)-5(e) is applied to amounts paid or incurred in taxable years ending on or after January 24, 2002. For M & A transaction costs occurring in tax years ending on or before 12/31/03, resolution of agreed LMSB examinations have generally resulted in the capitalization of all transaction costs (incurred up to the consummation of the acquisition) within a range of 50% to 65% of the applicable transaction costs. COMPLIANCE MEASURE For tax years ending on or before December 31, 2003, involving transaction costs incurred before December 31, 2003, in determining whether to audit the propriety of the taxpayer’s treatment of transaction costs in the acquisition of a trade or business, the auditor should consider whether the taxpayer’s return position falls within the prior Examination results referenced above. We caution auditors that where they have already expended significant resources in audit of this issue and the apparent results differ significantly from the 50% to 65% benchmark range, the auditor should pursue his/her determination based on the facts and circumstances of the audit. DURATION OF COMPLIANCE MEASURE This compliance measure shall not apply to any M&A transaction cost item paid or incurred on or after December 31, 2003. This compliance measure shall also not apply to amounts paid or incurred in taxable years ending on or after January 24, 2002 for purposes of computing the §481 adjustment, where the taxpayer has changed its method of accounting to comply with Treas. Reg. §1.263(a)-5(e). If you have any questions, please contact M&A Technical Advisor Barry Cooper at (212) 719-6438 or Diane J. Taylor at (310) 535-7515.