Corporate clients often want a transaction to close at the beginning or end of the day. Generally, the reason for choosing the beginning or end of the day is based on whether that days’ business activities should be attributed to the seller or the buyer. Unfortunately, tax rules do not always follow business desires and, in certain situations, an effective time that does not coincide with the Code can cause a major headache for a corporation’s tax department.
When a target corporation joins a consolidated group, its tax year ends at the end of the day on the closing date.1 Thus, closing day operations are generally reported by target on its tax return for the period ending on the closing date. When a purchase agreement contains an effective time of the closing at the beginning of the day on the closing date (i.e., 12:01 a.m.), the items are still reported on target’s tax return ending on the closing date. However, since the purchase agreement contains a 12:01 a.m. effective time, the target will have to collect any taxes attributable to business activities on the closing date from the buyer. Had the parties agreed to an effective time at the end of the day on the closing date (i.e., 11:59 p.m.), these accounting/tax issues would have been avoided. Additionally, to the extent permitted under the Code, the purchase agreement should provide specific allocations of various items (i.e., change of control bonuses) to pre-closing (target’s tax period ending on the closing date) and postclosing periods (target’s tax period beginning the day after the closing date) to ensure consistent tax reporting by both parties.
A recent 2012 Internal Revenue Service Legal Memorandum (the “2012 GLAM”)2 describes how a target corporation should report various items arising from an acquisition in the consolidated context in which the parties did not address the tax reporting of these items in the purchase agreement. In the 2012 GLAM, a calendar year acquiring corporation (“Buyer”) acquired a target corporation (“Target”) on November 30, 2012, by a merger of an acquiring subsidiary into Target, where Target shareholders exchanged their Target stock for cash (the “Acquisition”). The 2012 GLAM analyzes three items, all of which become deductible by Target on November 30 (the “Closing Date”).
Item 1 consists of amounts Target is required to pay its employees relating to the cancellation of non-qualified stock options and stock appreciation rights. These amounts became fixed on the Closing Date, but Target did not make payment until several days after the Closing Date. Item 2 consists of amounts Target was obligated to pay to service providers upon a successful closing.
These amounts also became fixed on the Closing Date. Finally, with respect to item 3, Buyer had requested that some of Target’s outstanding debt be retired. Before the Acquisition, Target and Buyer had agreed that Target would give its bondholders the opportunity to tender their bonds, two days prior to the Closing Date, at a price that reflects a premium over the adjusted price, but Target would not be required to purchase any of the bonds. After the Acquisition had closed but on the Closing Date, Target accepted the tendered bonds, and later that day, using its own funds or funds from Buyer, Target retired the bonds at a premium.
Under the consolidated return Regulations, Target has two taxable years: one that ends on the Closing Date (the “Pre-Closing Period”) and one (as a member of the acquiring group) that begins on the day after the Closing Date (the “Post-Closing Period”). The Regulations provide various rules relating to transactions that occur on the closing date, including the “end of day” rule and the “next day” rule.
Under the end of day rule, a corporation becomes or ceases to be a member of a consolidated group at the end of day on which its status as a member changes, and its tax year ends on that date.3 Accordingly, the deductions attributable to the events that occur on the Closing Date generally would be reported on Target’s Pre-Closing Period tax return, unless an exception applies.
The next day rule provides an exception to the end of day rule. The next day rule was added to the Regulations in 1994 in response to comments that a seller should not bear tax liability for post-closing events that are under the buyer’s control and of which the seller may be unaware. Under this rule, if a transaction occurs that is properly allocable to the Post-Closing Period, then Target must treat the transaction for all federal tax purposes as occurring on the first day of the Post-Closing Period.4 A determination that a transaction should be allocated to the Post-Closing Period will be respected if it is reasonably and consistently applied by all affected persons.5
With respect to items 1 and 2, the IRS determined that the obligation to pay and the amount of Target’s liability became fixed and determinable upon the closing of the Acquisition. These items were from transactions that preceded the Acquisition and that involved the performance of services for Target by its employees. Even though the consummation of the Acquisition fixed the liability to make the payments, the deductions were not attributable to a transaction on the Closing Date other than the Acquisition itself. Accordingly, the next day rule was inapplicable, and it was not proper or reasonable to allocate those deductions to the post-closing period. Instead, the deductions were properly governed by the end of the day rule and were required to be reported in the Pre-Closing Period. Such treatment is consistent with the purpose underlying the next day rule, since the items result from events not within the control of Buyer.
However, with respect to item 3, the IRS found that the next day rule may be appropriate. Target retired the bonds at a premium for cash after the closing with cash provided by Buyer. Since the deduction arises as a result of a payment in the Post-Closing Period based on a decision made by Target after the Closing Date, it was reasonable for Target to report the deduction on the Post-Closing Return as a member of the consolidated group with Buyer.
Although the Regulations provide rules for allocating various items between the pre- and postclosing periods, the parties’ allocation of certain items will be respected if it is reasonably and consistently applied by all affected persons.6 Accordingly, a buyer and seller/target should discuss and negotiate the tax reporting of various items and include provisions in the purchase agreement to ensure each party reports the transactions consistently.