The deductibility of an expenditure can greatly affect the benefit a tax payer receives from it. When evaluating the acquisition of another business, the issue becomes not only whether the expenditure is deductible rather than capitalizable but also whether it will reduce taxable income at all. Recently, the Tax Court considered several tax questions associated with a corporate acquisition.
In 1990 Schneider SA, a foreign corporation, began a hostile takeover of Square D Co. To guarantee sufficient funds, Schneider contracted for loans with two foreign banks. They required Schneider to pay a lee to tie up the funds and to agree to reimburse the banks for any legal expenses they incurred. To prevent the hostile takeover, Square D adopted compensation arrangements with its executives that included sizable golden parachute payments. Following an increase in the offer price, Square D agreed to be acquired in a reverse subsidiary merger. After the transaction Square D paid the fees due to the foreign banks. Schneider renegotiated the executives' employment contracts to include large cash payments so they wouldn't take the parachute payments. Square D deducted both the bank lees and the compensation payments. The IRS objected to both deductions.
Result. For the taxpayer on the bank lees and for the IRS on the compensation. The government argued the bank fees were not deductible as they were the obligation of the acquirer, not the taxpayer. It did not argue the costs should be capitalized as asset acquisition costs under Indopco and A.E. Staley. In other words it treated the lees as costs incurred on a normal business loan. By not treating the lees as acquisition costs, the government retreated from its former position of looking at all acquisition related costs as capitalizable and adopted a more fragmented approach. The taxpayer argued it was entitled to the deduction either because it was the successor to the corporation that incurred the costs or because another party incurred the costs for its benefit.
The Tax Court rejected the successor argument but considered Square D's alternative claim: It considered whether a taxpayer must be legally obligated to make a payment before it can deduct the payment since it did not incur the expenses. Based on its prior decision in Waring Prods. Corp., the court said that a corporation can deduct an expenditure even if it is not legally obligated to make the payment.
In its finding the court distinguished the current case from Lohrke, the precedent the taxpayer had cited. The Lohrke opinion does not follow the general rule that a taxpayer can deduct expenditures incurred for its benefit. Instead the case held that when a taxpayer pays an obligation a third party is unable to pay to protect or promote its business, it can deduct the expenditure. The facts in Square D did not support a finding that the original obligor could not pay the debt. However, according to the court, based on the specific facts of this case, the company was entitled to a …