The following article is adapted and reprinted from the M&A Tax Report, Vol. 9, No. 8, March 2001, Panel Publishers, New York, NY.

CONTINGENT LIABILITIES NONDEDUCTIBLE

By Robert W. Wood

Two recent Field Service Advice memoranda have addressed the question of the deductibility of contingent liabilities of the target (accrued before the target is acquired) in Section 338 transactions. In each case, these accrued liabilities of the target were paid by the selling corporation after the acquisition under an indemnity agreement. The two field service advices are numbered 200048006 and 200048009, and can be found, respectively, at Tax Analysts Doc. No. 2000-30936, 2000 TNT 236-16 (the first FSA) and Tax Analysts Doc. No. 2000-30939, 2000 TNT 233-17 (the second FSA).

The fact pattern in each FSA is similar. The acquiring corporation bought the stock of the target from the seller, and the parties made a Section 338(h)(10) election. The selling entity agreed to pay any taxes imposed on the target before the closing date of the sale. Some type of indemnity agreement is a feature of virtually any acquisition agreement, and an indemnity for taxes is nearly universal.

Before the acquisition, state tax authorities had issued a proposed notice of deficiency for unpaid franchise taxes. After the closing, the selling corporation settled with the state, paying franchise taxes plus interest. The acquiring corporation (not the target) took a deduction for the taxes and the interest paid by the selling corporation.

Yours, Mine or Ours?

But whose deduction really was this? Not surprisingly, the two FSAs conclude that the acquiring corporation is not entitled to a deduction for the accrued liabilities of the target, because the assumed liabilities are part of the cost of the target. Thus, the FSAs conclude that this payment is a capital expenditure. The acquiring entity, on the other hand, may deduct the interest accrued after the acquisition that is paid by the seller. Furthermore, the target will be able to make an upward adjustment in the basis of its assets for the contingent liabilities (and the pre-acquisition interest) when those become fixed and determinable.

Conversely, the acquiring corporation can make an offsetting downward adjustment in basis when the liabilities (and the pre-acquisition interest) are paid by the selling corporation. The target, however, does not receive an upward adjustment in basis for the post-acquisition interest when that becomes fixed. Yet, the target does reduce its basis when the seller pays the post-acquisition interest under the indemnity agreement.

Caution Needed

If all of this gets a bit topsy-turvy, it is certainly an illustration that 338(h)(10) elections, and their aftermath, require constant attention. Payments, even pursuant to an indemnity agreement, may or may not be deductible. The sad fact is that had the target company here settled with the state taxing agency and paid the state taxes and interest before it struck a deal with the acquiring corporation, there should have been little question about the deductibility of the taxes and interest.

Whether the target corporation was a cash basis taxpayer (unlikely) or an accrual basis taxpayer (likely, and those were the facts here), the taxpayer settling with the state before the deal gelled would have generated a deduction, albeit to the target, not to the acquiring company. Seems simple doesn't it?

Perhaps the simple moral of this little story is that at least a modicum of thought should be given to the precise effect of indemnity agreements. There is not only the cash to consider. Clearly, the big consideration to the corporate deal makers is to make sure that the liability is covered in an indemnity agreement. Still, there is also the treatment of the indemnity payment(s) themselves from a tax viewpoint to be reckoned with, especially when a timing difference can spell the difference between capital and ordinary treatment.

Contingent Liabilities Nondeductible, Vol. 9, No. 8, M&A Tax Report (March 2001), p. 1.