IRS to strip flexibility in allocation of M&A costs

Last week, the US Internal Revenue Service (IRS) issued proposed regulations seeking to limit how private equity firms allocate certain costs arising from a merger or acquisition that may result in portfolio companies paying significantly more tax. 

Where to allocate costs arising from an M&A deal must be sorted by the firm’s tax advisors. When the costs can be allocated to the target, they can be utilized as a tax shield in the company’s final tax filing (ending the day it’s acquired). But some costs can be carried over to the post transaction period, which can be beneficial from a tax standpoint. In the US, the decision turns on application of the “Next-Day” rule, which states that certain costs becoming fixed as of the closing date can be allocated to the buyer’s consolidated tax return as long as it’s done reasonably.

In the proposal, the IRS and the Treasury Department said the rule has “been inappropriately interpreted by taxpayers” and that they want to limit how much flexibility tax planners have when allocating success-based fees and similar costs.

Industry tax experts are criticizing the proposals, which will undergo a consultation period until June 4. In a client alert, McGladrey tax manager Amy Kasden said the proposed regulations use “a sledgehammer rather than a scalpel” to determine how certain M&A costs can be allocated “without regard to specific factual issues, such as who bears the burden of the costs and who satisfies the costs.”

Private equity firms have used the “Next-Day” rule to shift certain costs contingent on signing, like transaction fees, to the post-acquisition entity. These typically represent roughly 1 percent to 3 percent of the enterprise value, which can equate to hundreds of millions of dollars depending on the deal size.

If left unchanged, the finalized proposals may prompt tax advisors to consider new language in their M&A agreements to address the rule, predicted fellow McGladrey tax adviser Nick Gruidl in an interview with pfm. “For instance, private equity firms might try to find a way to structure certain costs arising after closing to include additional contingencies.”