Takeover defense expenditures: deductibility not necessarily precluded by National Starch

Tax Executive, The, May-June, 1990 by Mark B. Persellin

Takeover Defense Expenditures: Deductibility Not Necessarily Precluded by National Starch

Introduction

When confronted with a takeover attempt, a target corporation's board of directors must evaluate the tender offer in view of its fiduciary responsibility to shareholders. Regardless of whether a takeover attempt is "friendly" or "hostile," the directors will be compelled to take several takeover-related actions. For instance, an investment banker often is retained to value the corporation's stock and issue a "fairness" opinion. The costs associated with the various takeover-related actions can be substantial, often exceeding $1 million. Given the increased frequency with which corporations are confronted with takeover threats and the magnitude of the resultant costs, the proper tax treatment to be accorded those costs is of considerable importance to tax practitioners.

Despite the obvious importance of the issue, the deductibility of costs incurred by a target in response to a takeover attempt was only recently addressed by a court. In July 1989, the Tax Court provided the first judicial analysis of the tax treatment accorded a target's takeover-related expenses. In National Starch & Chemical Corp. v. Commissioner,(1) the court held that the costs incurred by a target in a friendly takeover constituted nondeductible capital expenditures. The Tax Court did not expressly address the treatment of expenses incident to resisting a tender stock offer, and there remains some question whether National Starch can be extended to preclude the deductibility of such expenses.

Until recently, the Internal Revenue Service (IRS) had assented to the deductibility of expenses incurred by a target in resisting a tender offer. In two different Technical Advice Memoranda (TAM),(2) the IRS held certain takeover defense costs to be deductible expenditures. In light of its recent victory in National Starch, however, the IRS has reversed its position. The IRS's current position, as set forth in a third TAM,(3) is that the Tax Court's decision in National Starch precludes the deductibility of costs incident to resisting a takeover attempt.

This article examines the proper tax treatment of a target's takeover-related expenses. The Tax Court's holding in National Starch is thoroughly analyzed as is the IRS's changing position on the issue. These and other authorities are then applied to expenses incurred by a target in both "friendly" and "hostile" takeover attempts in an effort to establish the proper tax treatment of such expenses. The article concludes with an argument favoring the deductibility of certain takeover-related expenses, particularly those incident to defending against a takeover attempt.

National Starch Decision

1. Background

In a meeting with National Starch and Chemical Corporation's (NSC) chairman of the board and its principal shareholder, representatives of Unilever expressed an interest in making a (friendly) tender offer for all of NSC's stock. The principal shareholder indicated that he would voluntarily relinquish his holdings (approximately 14.5 percent of the shares outstanding) as long as the takeover was structured in such a manner as to be tax-free to any interested shareholders. As a result, NSC's independent legal counsel was engaged to devise a tax-free structure for the transaction.

The resulting strategy, which had been blessed by the IRS in a favorable letter ruling, involved the formation of two new corporations within the Unilever corporate family for use in acquiring NSC's outstanding stock. One of those corporations (NSC Holding Corp.) exchanged its nonvoting preferred stock for each share of NSC's common stock, a transaction that was tax-free under section 351 to each participating NSC shareholder. The other new corporation (NSC Merger, Inc.) acquired the remaining NSC stock in a reverse subsidiary cash merger (into NSC), a transaction that was taxable to each participating NSC shareholder.

Prior to consummating the aforementioned transaction, NSC's board of directors had been instructed by its legal counsel that they had a fiduciary duty (under Delaware law) to ensure that the tender offer was fair to the shareholders. Specifically, the board was advised to retain an independent investment banking firm to value the stock and to serve as counsel in the event of any hostile takeover attempt by Unilever or other party. As a consequence, NSC engaged the services of Morgan Stanley & Co. to value the stock, to issue a fairness opinion, and to stand ready in the event of a hostile takeover attempt. Morgan Stanley ultimately submitted a report to NSC's management favoring the tender offer. The report was based, in part, on Morgan Stanley's belief that NSC affiliation with Unilever would produce synergistic effects.

The costs incurred by NSC with respect to the takeover included approximately $.5 million in legal fees and $2.2 million in fees for investment banking services. NSC originally had deducted only the investment banking fee. The company asserted the deductibility of the legal fees only after the IRS had issued a notice of deficiency in which the deduction for the investment banking fee was disallowed. The issue confronting the Tax Court was whether any of NSC's takeover-related expenses were deductible trade or business expenses under section 162 of the Internal Revenue Code.