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Northrop Grumman’s bid for TRW is a prominent example of what seems to be an increase in the number of unsolicited — and presumably unwanted — takeover attempts. In most cases, the target seeks, at least initially, to fend off the hostile suitor through a variety of devices. Some successful tactics involve a restructuring of the target; others, which can be equally successful, do not alter its capital structure. And in some cases the defense efforts are unsuccessful and the target’s board will be constrained to accept the acquirer’s offer, although generally at an increased price. The target can incur numerous expenses in the defense process and, to the maximum extent permissible, it naturally will seek to deduct these for tax purposes. What are its prospects? The law in this area is still evolving. It is not nearly as well settled as the rules that apply to expenses incurred in connection with friendly acquisitions. There, under the U.S. Supreme Court’s well-known INDOPCO decision, capital-expenditure status is the order of the day for costs directly related to the acquisition. See INDOPCO v. Commissioner, 503 U.S. 79 (1992). In INDOPCO, the Supreme Court said expenses incurred by a target in connection with its friendly acquisition were nondeductible capital expenditures because the acquisition resulted in long-term benefits to the target. The Court pointedly rejected the argument that the expenses were deductible because they did not result in the creation or enhancement of a “separate and distinct additional asset.” Creation or enhancement would be sufficient to warrant capitalization of an expense, the Court said, but was not a prerequisite. Capital-expenditure treatment is appropriate when the expense leads to the production of a long-term benefit, it held. The Internal Revenue Service’s views on tax treatment of expenses incurred by the target in a hostile deal are based on the INDOPCO rationale. In evaluating the tax character of the expenses, the possible outcomes of a takeover attempt are key. A target may mount what it considers a successful defense that allows it to preserve its independence. The IRS has announced that the target’s costs in such cases are not deductible if they produce for the target a long-term benefit. Most observers believe that position is erroneous. They feel the expenses ought to be deductible in any event. Professors Martin Ginsburg and Jack Levin, for example, liken them to deductible repair and maintenance expenses: Where, they ask, is the long-term benefit when all the target has accomplished by its successful defense effort is to preserve the status quo? It seems likely that when a court considers this issue for the first time, it will side with the camp that supports a current deduction for this variety of defense outlay. On the other hand, if a defense effort succeeds because the target has entered into an acquisition agreement with a white knight, the expenses incurred will have to be capitalized as they would have been in the case of a friendly acquisition. The fact that the impetus for the white-knight transaction was a hostile entreaty would not be sufficient to sustain a deduction. More intriguing in white-knight cases is whether it is possible to deduct the portion of the expenses that can be associated with consideration by the target’s advisers of alternative defense strategies. After all, it is well settled that fees and expenses paid in connection with abandoned transactions are deductible. The answer appears to be no. Those expenses cannot be deducted when advisers are considering “mutually exclusive alternative plans,” as opposed to “multiple suggestions falling under one plan.” This is the standard for deductibility set forth by the 6th U.S. Circuit Court of Appeals in the recent United Dairy Farmers decision, and it will deny a deduction here because the alternatives considered by the target’s advisers clearly seem mutually exclusive. See United Dairy Farmers v. United States, 267 F.3d 510 (6th Cir. 2001). The final scenario involves the case of an unsuccessful defense — when the target is ultimately acquired by the hostile suitor. In the Federated Department Stores case, the bankruptcy court permitted the deduction of a breakup fee paid by the target to a spurned white knight shortly after Federated’s acquisition by the Campeau interests. The court concluded the takeover did not provide the type of synergy found in the INDOPCO situation because — as events would later prove — the Campeau interests were woefully inexperienced in Federated’s business. The court said the fee was simply an attempt to defend the business against attack, a category of expenditure that had always been eligible for a deduction. See In re Federated Dept. Stores, 135 B.R. 950 (Bankr. S.D. Oh. 1992), aff’d 171 B.R. 950 (S.D. Ohio 1994). Many practitioners, however, feel Federated is not a particularly good precedent. The court’s decision was undoubtedly influenced by the fact that, shortly after the acquisition, both Campeau and Federated were enmeshed in bankruptcy proceedings — and it’s hard to find a long-term benefit in such a situation. The A.E. Staley Manufacturing case, a more conventional scenario with a happier ending, provides even the most careful practitioner solid precedent for securing a deduction for the target’s defense expenses. See A.E. Staley Manufacturing Co. v. Commissioner, 105 T.C. 166 (1995) rev’d and rem’d, 119 F. 3d 482 (7th Cir. 1997). An unsolicited offer was made and initially rejected. The corporation hired investment bankers to explore alternatives, but the bankers were unable to come up with a viable plan. Accordingly, the target’s board agreed to accept the suitor’s offer, though at a higher price. The IRS argued, and the Tax Court agreed, that the banking fees were not deductible under INDOPCO: They were incurred by the target in connection with a change in its ownership that had “extended future consequences” to the target. The Tax Court’s decision surprised many. The court had adopted a standard that seemed to go beyond INDOPCO — one that would require capitalization of expenses, not on a showing of future benefits, but because of the prospect of future consequences. Mercifully, the decision was reversed on appeal. The appeals court said expenses incurred in defending a business from attack had been and remained deductible, and that the INDOPCO Court had neither abrogated nor even addressed this venerable principle. The banking fees were deductible because they were not connected in any way to the acquisition that ultimately occurred. More specifically, the court found that none of the services performed by the bankers “facilitated the acquisition.” The services simply comprised failed attempts to engage in alternative capital transactions. Accordingly, it can now be safely said that expenses incurred in defending against an unwanted takeover, even if it eventually succeeds, are deductible. Robert Willens is a tax and accounting specialist at Lehman Brothers Inc. He is also an adjunct professor of finance at Columbia Business School. Copyright (c)2002 TDD, LLC. All rights reserved.

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