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In a ruling that limits the cost of acquisitions, a federal appeals court has held that the salaries of corporate officers incurred during such deals can be deducted as an ordinary expense in the year they were incurred. A three-judge panel of the 8th U.S. Circuit Court of Appeals overturned a U.S. Tax Court opinion from last year that sided with the Internal Revenue Service’s position that such salaries had to be amortized over many years as capital expenditures. Corporate tax lawyers hailed the decision as a victory. “The ultimate question is whether the expense is directly related to the transaction which provides the long-term benefit,” the appeals court wrote. “In this case, there is only an indirect relationship between the salaries (which originate from the employment relationship) and the acquisition (which provides the long-term benefit).” The closely-watched case involved Davenport Bank & Trust Co., an Iowa bank that deducted the salaries of its corporate officers as an ordinary expense during its merger with Norwest (which eventually merged with Wells Fargo & Co.). In 1990, Norwest began merger discussions with Davenport that resulted in the companies combining the following year. During that time, Davenport had several officers working on various aspects of the deal. However, none of them were hired specifically for the merger. Of the salaries paid to those officers, only $150,000 could be attributed to the merger. The company wanted to write off that amount that year as an ordinary expense. But the IRS refused to allow it, and last year, the U.S. Tax Court ruled in favor of the government agency. Last week, the appeals panel found that the tax court had erred in its interpretation of a 1992 U.S. Supreme Court ruling, known as Indopco. In that landmark opinion, the Supreme Court concluded that expenses directly incurred by a target company during a friendly takeover were capital expenses. Since that ruling, the IRS has sought to expand the category of capital expenditures related to mergers. The legal opinion represents the latest round by courts to “reign in the IRS which has become aggressive about capitalizing all manner of expenses,” said Robert Willens, a tax analyst and managing director for Lehman Brothers Inc. If the tax court ruling hadn’t been overturned, the result would have been an accounting nightmare. Executives would have had to separate the time they spent on the deal from their normal work functions, he explained. “Imagine getting Sandy Weill to keep track of the time he spends on acquisitions,” Willens said. And, it wouldn’t have only applied to top corporate officers. “In-house lawyers and people who would be out doing due diligence would be affected,” said Jim O’Hara, the group coordinator of the tax practice at the Cleveland law firm Jones Day Reavis & Pogue. The appeals court in St. Louis didn’t find that result practical. “Lest one should doubt that paying salaries to corporate officers is a transaction ‘of common or frequent occurrence’ in the business world, we note that courts have traditionally permitted current deductions for expenses attributable to salaries similar to those at issue here,” the panel wrote. “Davenport’s officers had always received salaries, even before the acquisition was a possibility. There was no increase in their salaries attributable to the acquisition, and they would have been paid the salaries whether or not the acquisition took place.” The appeals court also concluded that more of the cost of due diligence in connection with acquisitions can be deducted up to the point that the company decides to go ahead with the deal. The cut-off for whether such expenses can be deemed ordinary or should be capitalized occurs when a real plan for an acquisition has arisen. “The mere fact that you’re out kicking some tires doesn’t mean you’ve adopted an acquisition plan with a clear target in sight,” O’Hara said. Nevertheless, John Coffee, who teaches corporate finance at Columbia University School of Law, spoke cautiously of the ruling. He pointed out that the decision only binds the IRS in the Eighth Circuit, which includes Arkansas, Iowa, Missouri, Nebraska, Minnesota and the Dakotas. The agency may take the fight to another federal court. “It could still be an open battle,” Coffee said. A Department of Justice spokeswoman said on behalf of the IRS that no other cases are pending before federal judges; however, the agency may have some internal cases. Also, no decision has been made by the IRS to appeal for a rehearing by the Eighth Circuit or to go to the Supreme Court, the spokeswoman said. Copyright (c)2000 TDD, LLC. All rights reserved.

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