76 Tax Notes 689

Tax Notes

AUGUST 4, 1997

DEPARTMENT: Viewpoint (VWP)

CITE: 76 Tax Notes 689

HEADLINE: 76 Tax Notes - SNARLING FOR THE CAMERAS: HOSTILITY AND TAKEOVER EXPENSE DEDUCTIONS. (Section 162) (Doc 97-22503 (3 pages))

AUTHOR: Johnson, Calvin H.

University of Texas

CODE: Section 162

SUMMARY:

Professor Calvin Johnson weighs in on the fast-becoming- controversial Staley decision on the deductibility of takeover defense expenses.

Calvin H. Johnson is professor of law at the University of Texas. He thanks his colleague Mark Gergen for a helpful reading of a prior draft.

SNARLING FOR THE CAMERAS: HOSTILITY AND TAKEOVER EXPENSE

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DEDUCTIONS

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by Calvin H. Johnson

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In A.E. Staley Manufacturing Co. v. Commissioner, /1/ the Seventh Circuit reversed the Tax Court to allow a target corporation to deduct its investment bankers' fees allocable to an unsuccessful attempt to defeat a hostile takeover. Some of the $12.5 million fees facilitated the takeover, the Seventh Circuit held, and were capital expenditures creating future benefits. The bulk were defensive, however, and could be deducted. The Tax Court on remand has the unenviable task of separating out the costs allocable to hostile motives in a unitary transaction that should have generated no deductions.

Staley was argued as if the only issue was whether the fees created a corporate-level investment or capital expenditure. The Tax Court majority opinion had found the fees gave future benefits to the target; /2/ the Seventh Circuit, quite plausibly, found that the fees did not create future corporate-level benefits insofar as they were hostile. The absence of a future benefit or investment at the corporate-level does not, however, justify the deduction:

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o Stock Price Explains It. Resistance to the takeover increased

the price paid to the shareholders in the takeover by $ 167

million. Hostility is always rational in the haggling over the

price. There did not need to be any corporate-level benefit,

given the primary benefit to the shareholders.

o Tax-Exempt Sale. Even if we were to posit some corporate-level

justification for the fees, the takeover was a tax-free sale

of business assets in which no gain was recognized. Fees

associated with tax-exempt sales should not be deducted.

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1. SHAREHOLDER BENEFIT EXPLAINS IT ALL.

The only meaningful distinction between a hostile and a friendly takeover is the price to be paid to the shareholders. Every takeover is hostile when the price is too low and every takeover becomes friendly when the price is right. The takeover involved in Staley was hostile when the offering price on April 18 was $32 a share, but the target's board of directors, for all their hostility, approved the offer unanimously when the acquirer raised the offer to $36.50 a share on May 13. In every successful takeover, the target and acquiring corporations are adverse as to price to be paid to the target shares, so every successful takeover has hostility at the start of the negotiations. To separate out a hostile part of the haggling over stock price in a single unitary takeover on the basis of corporate motive is a rule just inviting abuse. In future cases, the parties will be acting like professional wrestlers, snarling for the cameras, just to get some extra tax deductions.

The increased price paid for shares in the haggling over price, in the period from the first to the winning offer, is a sufficient explanation for the target's costs in resisting the initial overture. As Judge Renato Beghe explained in the Tax Court below, the increase in the offer from $32 to $36.50 a share gave the shareholders an extra $167 million, /3/ which was a lot more than the target's total costs resisting the offer. There did not need to be any benefits from the target's fees at the corporate level and indeed there probably were none.

2. MANAGEMENT HOSTILITY DOES NOT MATTER.

A takeover is usually called hostile because management of the target opposes it. The acquirer in Staley had been critical of the target's management before the acquisition and when the acquisition succeeded, the acquirer fired the target's top management and the headquarters staff. Putting management's compensation package at risk is threatening to current management. It tends to make them unhappy.

But management's hostility does not count. It was not their $12.5 million that was paid to the bankers, but the shareholders'. Management is supposed to be serving as fiduciaries of the shareholders to maximize the price of corporate shares. The appropriate function of the $12.5 million was to increase the price of target shares. If the fees were not in fact related to stock price, they certainly should have been.

If the takeover had been abandoned in full, then the fees would have been totally wasted. A deduction would then have been proper. Still, so long as the takeover succeeded, at an increased price that more than covered the fees, we should ignore management's claims of hostility -- or at least refuse to distinguish the hostility from the normal haggling over price.

3. CORPORATE FUTURE BENEFIT DOES NOT MATTER.

Staley was unfortunately argued as if the issue was whether the takeover expenses created a corporate-level asset or investment. Corporate expenditures that have significant future value are called investments or capital expenditures. In INDOPCO, Inc. v. Commissioner, /4/ the Supreme Court held that a target corporation's costs of tax-free reorganization were capital expenditures, creating basis in an unamortizable asset called improved corporate structure.

It is quite plausible that there was no corporate-level asset or added target income in Staley. The business in Staley contracted in the takeover. The acquirer had announced beforehand that it wanted to refocus the target back on its original core business. As soon as the takeover was completed, the acquirer sold off part of the target business to pay off some of its acquisition debt. The expenditures plausibly did not create any greater taxable income or income- generating asset on the corporate level for the target, either currently or in the future. For that matter, there were no corporate- level benefits in INDOPCO either. /5/

The absence of added operating income for the target, if anything, works against the deduction. The target was not trying to make any current or future taxable income. Without any current or future operating income the fees can be matched to, we must look to some other explanation to explain the fees and determine their character. There is an obvious candidate: The fees were first and proximately related to increasing the purchase price of the shares.

When a corporation pays expenses for the primary benefit of its shareholders, those expenses are considered to be constructive dividends and not deductible by the corporation. The test is the 'primary benefit' rule: Did the expenditures primarily benefit the shareholders or primarily benefit corporate taxable income or corporate operations? /6/ The issue is not just whether the defensive costs were sufficiently or arguably related to the business income. To permit a subordinate business connection to justify a deduction, when the shareholder benefit is more important, would permit 'a swallowing up of the greater by the lesser.' /7/

Comparing the shareholder benefit with the business benefit must also be done by an objective test. 'A matter so real as taxation must depend on objective realities, not on the varying subjective beliefs of individual taxpayers.' /8/ Taxpayer self-serving claims cannot settle the issue where a more objective test is available. /9/

In Staley, there is a creditable objective witness to the relative importance of the business connection and the share price -- the market price of the shares themselves. The market evaluating the target did not think that the value of the target business under current management was higher than the business in new hands: the market price of the stock went up in the takeover, which indicates that the market did not think that the defensive expenses improved the business. Without any improvement in the business, the attempt to get a higher price for the shares -- a shareholder benefit -- becomes the only explanation for the defensive fees. Any serious application of the primary benefit test, in any event, would find that the benefit to stock price predominated. The Seventh Circuit, by contrast, found that the value of defending existing business practices was the predominant cause for the target's fees when the market could not even see any positive value from the defending.

4. COST OF TAX-EXEMPT SALES.

The motives for the target's fees in Staley are not to be found at the corporate level, but even if they were, the fees should not be deducted. The takeover in Staley created taxable income to the shareholders in selling their shares, but for the corporation no gain was recognized in the sale. On the corporate level, the takeover was a tax-exempt sale of corporate assets. Neutral tax accounting for a cost associated with a tax-exempt sale requires that the costs be added to the basis for the various business assets transferred in the takeover. The extra basis would then be recognized as the assets are sold or used up in the business, so that the costs would be matched against the gain or income from the assets, as the gain or income is recognized for tax purposes. It is a violation of sound accounting, the sin of mismatching, to defer the gain on the assets, but allow an ordinary deduction for costs immediately. Under sound tax accounting, the 'cost of any given type of income is to be accorded the same tax character as the income produced.' /10/ So long as there was unrealized appreciation on the sale of assets, the fees should be deferred until the appreciation is recognized.

CONCLUSION

Staley is now law in the Seventh Circuit, but it does not need to be followed elsewhere for taxpayers in other circuits. Even in the Seventh Circuit, the scope of the decision can be narrowed: The court presumed that absence of future benefits on the corporation level implied that a deduction must be allowed. The court thus gave no considered judgment as to whether the shareholder benefits (or even the tax-exempt nature of the sale to the corporation) might disallow the deduction, even though -- and especially because -- there was no corporate-level benefit. The court did not do a serious job of comparing the shareholder and business benefits from the transaction to apply the primary benefit test, but the next court will distinguish Staley and do a better job. Staley is an error, but the courts in their wisdom will have chances to correct it.

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FOOTNOTES

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/1/ ___ F.3d. ___ , 80 AFTR2d par. 97-5028, No. 96-1940 (July 1, 1997), rev'g and rem'g 105 T.C.166 (1995).

/2/ Eleven of the Tax Court judges joined in the Halpern majority opinion, which treated the issue as one of capital expenditures or investments at the corporate level. Four of the Tax Court judges joined in the Beghe opinion, which treated the issue as one of providing shareholder benefit. Beghe joined in both opinions because he was willing to indulge in the majority view that the expenditures gave future corporate benefits, but he would disallow the deduction, in any event, because the costs were sufficiently explained by increase in the price paid to shareholders.

/3/ 105 T.C. at 201 (joined by Swift, Wells, and Vasquez, JJ).

/4/ 503 U.S. 79 (1992).

/5/ In INDOPCO itself, the court plausibly used the future benefit test as a fiction to reach a proper result, because, even in INDOPCO, the taxpayer made a very persuasive case that there was no corporate-level benefit: 'After the transaction, National Starch's management (its directors and officers) remained in place, its key employees entered into employment contracts with the company, and its business (adhesives, starches, and specialty chemical products) continued in the same way as before. Unilever the acquirer did not make any changes in National Starch's operations, did not provide National Starch with any significant technological or financial assistance or legal, administrative, or accounting services and did not materially increase its purchases of National Starch products.' Petition for Writ of Certiorari in INDOPCO, Inc. v. Commissioner, Doc 90-1278, at 3 (1990). INDOPCO is rightly decided for reasons explained in this viewpoint, but not because the costs were plausibly investments at the corporate level.

/6/ See, e.g., Jack's Maintenance Contractors, Inc. v. Commissioner, 703 F.2d 154, 156 (5th Cir. 1983) (legal fees to keep CEO out of jail); Sammons v. Commissioner, 472 F.2d 449, 452 (5th Cir. 1972) (contributions reducing shareholder guarantees); Loftin and Woodard, Inc. v. United States, 577 F.2d 1206, 1215 (5th Cir. 1978).

/7/ Sammons v. Commissioner, 472 F.2d 449, 452 (5th Cir. 1972).

/8/ Lynch v. Commissioner, 273 F.2d 861, 972 (2d Cir. 1955) (Friendly, J.) (step-transaction doctrine used to deny interest deduction on grounds debt was a sham).

/9/ When benefit to shareholders is implicated, it should be noted, the issue is not whether the expenses are minimally justified in the business under management's sound discretion. Wise officers, it turns out, defend their own compensation with a vengeance and pay out dividends as well as they incur operating expenses, so that there is nothing in their wisdom that negates the dividend nature of the expenditure. The courts, accordingly, must weigh the relative benefit to taxable operating income and to shareholders.

/10/ Alphaco, Inc. v. Nelson, 385 F.2d 244 (7th Cir. 1967).

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