Investment adviser's merger support payment is deductible

Plain-English summary

An investment adviser paid a target company's shareholders to encourage approval of the target's acquisition by an investment company the adviser managed. The adviser expected the acquisition to increase its management fees because those fees depended partly on the investment company's asset size and performance. The IRS concluded that the payment was an ordinary and necessary business expense under section 162 because financial inducements were common in the industry and the payment was intended to increase the adviser's business. The payment did not acquire or create an intangible, create a separate transferable property right, or facilitate a transaction that the capitalization regulations covered. It was therefore deductible and did not have to be capitalized under section 263.

Ruling snapshot

• Question: Was the adviser's payment to the target's shareholders deductible under section 162, or did section 263 require capitalization?
• Outcome: approved
• Key authorities: IRC §§ 161, 162, 263; Treas. Reg. §§ 1.162-1, 1.263(a)-4, 1.263(a)-5

Full text (IRS public release)

Internal Revenue Service                                          Department of the Treasury
                                                                  Washington, DC 20224

Number: 201736002                                                 Third Party Communication: None
Release Date: 9/8/2017                                            Date of Communication: Not Applicable
Index Number: 263.00-00
                                                                  Person To Contact:
------------------------------------------                        -----------------, ID No. -----------
------------------------------------------------------------      Telephone Number/Fax Number:
-----------------                                                 ---------------------- ----------------------
-----------------------------------                               Refer Reply To:
---------------                                                   CC:ITA:B2
--------------------------------------                            PLR-101047-17
                                                                  Date:
                                                                  June 08, 2017




Legend

Taxpayer                            =       -------------------------------------------                           ---------
-------------------------------------------

Acquirer                            =        ----------------------------------

Target                              =        ------------------------------

Parent                              =        --------------------------------

Date1                               =        ------------------

Date2                               =        -------------------

Date3                               =        ----------------------

Support Payment                     =        -----------------


Dear -----------------:

This letter is in reply to a private letter ruling request dated January 3, 2017, filed by
Taxpayer. Taxpayer requested rulings on the federal income tax consequences of a
certain payment made by Taxpayer (Support Payment).

PLR-101047-17                                2

RULINGS REQUESTED

   (1) Whether the Support Payment paid by Taxpayer to the shareholders of Target is
       deductible by Taxpayer under § 162 of the Internal Revenue Code.

   (2) Whether the Support Payment paid by Taxpayer to the shareholders of Target is
       required to be capitalized by Taxpayer under § 263.

FACTS

Taxpayer represents that the facts are as follows:

Taxpayer is a limited liability company that serves as an investment adviser to Acquirer.
Taxpayer is an indirect subsidiary of Parent. Parent and Acquirer are separately owned
and are not related under § 267(b).

Taxpayer manages Acquirer pursuant to an investment management agreement (IMA)
dated Date1. Under the IMA, Acquirer agrees to pay Taxpayer: (1) a base
management fee, which is an amount equal to a percentage of Acquirer’s total assets;
and (2) an additional fee consisting of (a) a percentage of Acquirer’s net investment
income (interest income, dividend income, and other fee income, minus certain
operating expenses) and (b) a percentage of Acquirer’s cumulative aggregate realized
capital gains minus the sum of cumulative aggregate capital losses and aggregate
unrealized capital depreciation. The IMA remains effective provided that its continuance
is approved at least annually by (1) Acquirer’s board of directors or by vote of
shareholders holding a majority of the outstanding voting securities of Acquirer and (2)
the vote of a majority of Acquirer’s directors who are not parties to the IMA or
“interested persons” as defined in Section 2(a)(19) of the Investment Company Act of
1940. The IMA may be terminated at any time upon 60 days written notice by a vote of
the stockholders holding a majority of the outstanding voting securities of Acquirer, by a
vote of Acquirer’s directors, or by Taxpayer.

On Date2, Acquirer entered into a merger agreement to acquire Target, subject to the
approval of Target’s shareholders. The merger is intended to be treated as a taxable
acquisition of Target’s stock by Acquirer for U.S. federal income tax purposes and will
result in Acquirer indirectly acquiring all of Target’s assets. As a result of the merger,
Taxpayer expects that its future fees under the IMA will increase because of Acquirer’s
increase in asset size. The merger closed on Date3 in which all of the outstanding
shares of Target stock were exchanged for Acquirer’s stock and cash.

In connection with the merger, in addition to payments per share from Acquirer and
Target, Target’s shareholders will receive a payment per share directly from Taxpayer
(totaling the Support Payment). Taxpayer will receive no stock, cash, stock, or other
property from Target, Acquirer, or any of their shareholders, employees, or affiliates in

PLR-101047-17                               3

consideration for providing the Support Payment to Target’s shareholders. Taxpayer is
transferring the Support Payment to Target’s shareholders to induce them to approve
the merger with Acquirer because Taxpayer expects the merger will result in earning
higher fees from Acquirer under the IMA. Taxpayer represents that investment advisors
commonly provide financial inducements to attract and retain investors in entities that
they advise.

LAW AND ANALYSIS

Ruling Request 1:

Section 162 provides generally that taxpayers may deduct all ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade or business.
See also § 1.162-1(a) of the Income Tax Regulations. In order to be deductible under §
162, an expenditure must be (1) paid or incurred during the taxable year, (2) related to
carrying on a trade or business, and (3) ordinary and necessary for the trade or
business. Commissioner v. Lincoln Savings and Loan Ass'n, 403 U.S. 345, 352 (1971).

The term "ordinary" refers to an expenditure that is normal, usual, or customary.
Deputy v. du Pont, 308 U.S. 488, 495 (1940). An expenditure may be ordinary if it is
commonly and frequently incurred in the type of business involved. Id. (citing Welch v.
Helvering, 290 U.S. 111, 114 (1933)).

The term "necessary" means appropriate and helpful to the development of the
taxpayer's business. Commissioner v. Tellier, 383 U.S. 687, 689 (1966) (quoting
Welch, 290 U.S. at 113); Commissioner v. Heininger, 320 U.S. 467, 471 (1943).

Taxpayer requests that it be allowed to deduct the Support Payment as an ordinary and
necessary business expense under §162. Taxpayer represents that the Support
Payment is usual in its industry as investment advisors commonly provide financial
inducements for the ordinary business reason of attracting and retaining investors in
entities that they advise. Thus, we conclude that the Support Payment is an ordinary
expense under § 162. Further, Taxpayer made the Support Payment with the hope of
financial return as the merger of Target and Acquirer will increase Acquirer’s total
assets, thereby increasing the investment advisory fees paid to Taxpayer. The Support
Payment is appropriate and helpful to the development of Taxpayer’s business, and
therefore, the Support Payment is a necessary expense under § 162.

Accordingly, based solely upon the information submitted, we conclude that the Support
Payment is deductible as an expense under section 162(a), subject to the capitalization
rules of § 263(a).

PLR-101047-17                                 4

Ruling Request 2:

Under § 161, if a cost is a capital expenditure, the capitalization rules of § 263 take
precedence over the deduction rules of § 162. Commissioner v. Idaho Power Co., 418
U.S. 1, 17 (1974). Therefore, a capital expenditure cannot be deducted under §162,
regardless of whether the expenditure is ordinary and necessary in carrying on a trade
or business.

Section 263(a) generally prohibits deductions for capital expenditures. Section
1.263(a)-4 of the Income Tax Regulations provides rules for applying § 263(a) to
amounts paid to acquire or create intangibles. Section 1.263(a)-5 provides rules for
applying § 263 to amounts paid that facilitate an acquisition of a trade or business, a
change in the capital structure of a business entity, and certain other transactions.

Section 1.263(a)-4(b)(1) provides that a taxpayer must capitalize: (i) an amount paid to
acquire an intangible (see § 1.263(a)-4(c)), (ii) an amount paid to create an intangible
(see § 1.263(a)-4(d)), (iii) an amount paid to create or enhance a separate and distinct
intangible asset (see § 1.263(a)-4(b)(3)), (iv) an amount paid to create or enhance a
future benefit identified in the Federal Register or in the Internal Revenue Bulletin as an
intangible for which capitalization is required under this section, and (v) an amount paid
to facilitate the acquisition or creation of an intangible (see § 1.263(a)-4(e)).

Section 1.263(a)-4(c)(1) provides that, in general, a taxpayer must capitalize amounts
paid to another party to acquire any intangible from that party in a purchase or similar
transaction. See also § 1.263-4(b)(1)(i). Taxpayer did not pay the Support Payment to
Target’s shareholders to acquire any intangible from Target in a purchase or similar
transaction. Taxpayer did not receive any stock, cash, stock, or other property from
Target, Acquirer, or any of their shareholders, employees, or affiliates in consideration
for providing the Support Payment. As a result, the Support Payment does not
constitute an amount paid to acquire an intangible within the meaning of § 1.263(a)-4(c).

Section 1.263(a)-4(d)(1) provides that a taxpayer must capitalize amounts paid to create
an intangible described in that paragraph. See also § 1.263(a)-4(b)(1)(ii). The Support
Payment is not one of the types of created intangibles that are listed in § 1.263(a)-4(d).
As relevant here, § 1.263(a)-4(d)(6)(i)(B) provides that a taxpayer must capitalize
amounts paid to another party to create, originate, enter into, renew, or renegotiate with
that party an agreement providing the taxpayer the right to provide or receive services
(or the right to be compensated for services regardless of whether the taxpayer
provides such services). First, by paying the Support Payment to Target, Taxpayer is
not creating, originating, entering into, renewing, or renegotiating with Target any
agreement providing the right to provide or receive services or the right to be
compensated for services from Target. The IMA is an agreement with Acquirer, not
Target, and Taxpayer is receiving nothing in return for paying the Support Payment.
Second, Taxpayer made the Support Payment with the mere hope and expectation of

PLR-101047-17                                5

developing or maintaining a business relationship with Acquirer, and the Support
Payment is not contingent on the origination, renewal, or renegotiation of the IMA. See
§ 1.263(a)-4(d)(6)(ii). Last, because the IMA may be terminated by Acquirer with 60
days notice, the IMA does not provide Taxpayer a right to use property or to provide or
receive services. See § 1.263(a)-4(d)(6)(iv). Therefore, the Support Payment is not a
created intangible required to be capitalized under § 1.263(a)-4(d).

Whether an amount paid creates or enhances a separate and distinct intangible is
provided in § 1.263(a)-4(b)(3). See § 1.263(a)-1(b)(iii). Section 1.263(a)-4(b)(3)(i)
provides that the term separate and distinct intangible asset means a property interest
of ascertainable and measurable value in money's worth that is subject to protection
under applicable state, Federal or foreign law and the possession and control of which
is intrinsically capable of being sold, transferred or pledged (ignoring any restrictions
imposed on assignability) separate and apart from a trade or business. Taxpayer
receives nothing in return for making the Support Payment to Target’s shareholders;
i.e., Taxpayer makes the Support Payment solely to motivate Target’s shareholders to
approve the merger with Acquirer. Taxpayer has a mere hope that its business will
increase with the merger. Taxpayer has received no property interest or right that is
intrinsically capable of being sold, transferred or pledged by making the Support
Payment. The point is further supported by the fact that the IMA is terminable at any
time by Taxpayer or Acquirer. Therefore, the Support Payment is not an amount paid to
create or enhance a separate and distinct intangible asset within the meaning of
§ 1.263(a)-4(b)(3).

Further, the Support Payment is not made to create or enhance a future benefit
identified in the Federal Register or the Internal Revenue Bulletin. Also, the Support
Payment does not facilitate the acquisition or creation of an intangible because no
intangible is acquired or created by the payment, as discussed above. Therefore §
1.263(a)-4(b)(1)(iv) and (v) do not apply to the Support Payment.

Section 1.263(a)-5(a) provides that a taxpayer must capitalize an amount paid to
facilitate certain transactions (described in § 1.263(a)-5(a)(1)-(10)), without regard to
whether the transaction is comprised of a single step or a series of steps carried out as
part of a single plan and without regard to whether gain or loss is recognized in the
transaction. Under the facts represented, the Support Payment is not paid to facilitate
any of the transactions listed in §1.263(a)-5(a). Therefore, the Support Payment is not
required to be capitalized under § 1.263(a)-5.

Accordingly, the Support Payment is not an intangible described in the regulations
accompanying § 263 and is not required to be capitalized under that section.

PLR-101047-17                                 6

CONCLUSIONS

   (1) The Support Payment paid by Taxpayer to the shareholders of Target is
       deductible by Taxpayer under § 162.

   (2) The Support Payment paid by Taxpayer to the shareholders of Target is not
       required to be capitalized by Taxpayer under § 263.

The ruling contained in this letter is based upon information and representations
submitted by Taxpayer and accompanied by a penalty of perjury statement executed by
an appropriate party. While this office has not verified any of the materials submitted in
support of the request for a ruling, such material is subject to verification on
examination.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter.

This ruling is directed only to Taxpayer, who requested it. Section 6110(k)(3) provides
that it may not be used or cited as precedent.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.

PLR-101047-17                                           7

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to Taxpayer’s authorized representative.


                                                              Sincerely,



                                                              DAVID M. CHRISTENSEN
                                                              Assistant to the Branch Chief, Branch 2
                                                              Office of Associate Chief Counsel
                                                              (Income Tax & Accounting)


Enc: copy for section 6110 purposes

cc:    ----------------------- ----------------------------

       Internal Revenue Service
       Attn: Director --------------------------------
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