Tax deductibility of deal fees

The M&A process is expensive. Tax deductibility for advisers' costs is itself a valuable asset.

Recent changes to the UK's loss relief rules greatly enhance the prospects of actually being able to use any deduction which can be obtained.

The decision of the first tier tribunal in Centrica Overseas Holdings Limited v HMRC indicates that a greater level of deductibility is achievable than might previously have been thought to be the case, but also illustrates one very significant pitfall. 

The Centrica group incurred significant accounting, legal and, dwarfing the others, banking advisory fees, on a troublesome disposal. The first tier tribunal found that the majority of the costs were in principle deductible. 

The crucial distinction is between costs incurred in evaluating a deal and costs incurred in implementing a specific deal. HMRC argued that the watershed moment came right at the outset, before any of the advisers were engaged, when the Centrica group decided to pursue a disposal. However Centrica successfully argued that the correct date was the decision of Centrica's board to approve the actual transaction with the ultimate purchaser, almost two years later and only a couple of weeks before the deal completed. The banking fees were generally deductible even though they were wholly contingent on completion of a successful transaction.

So far so good, but the costs were incurred by an intermediate holding company. The original plan had been for that company to dispose of its Dutch subsidiary but, in the end, the transaction had to be completed by that subsidiary instead selling its assets (mainly shares in other subsidiaries). 

HMRC successfully argued that all the decisions were taken at Plc level, meaning that they could not be expenses of the holding company’s management business because it hadn’t undertaken any management. The holding company did not have a good record of holding board meetings - and there is a cautionary tale here - but it appears that the finding is based on more than mere failure to observe formalities. The directors of the holding company were fully involved in the transaction, but this was found to be in their capacity as employees of Plc rather than as directors and so was not enough. 

If the decision stands, following an inevitable appeal, it will be a potential bar for many holding companies, as it sets an unrealistic standard for holding company management before deductibility can be obtained. 

It does appear that if the costs had simply remained at Plc level, rather than being charged to the holding company, the outcome would have been different. However, if you apply this to a private equity context, where the key commercial decisions are being made by the fund's manager but as a matter of commercial necessity costs need to be borne within the relevant deal structure, the fix is not so simple. 

Fortunately, there is scope to argue that this aspect of the decision should not apply to a holding company disposing of its immediate subsidiary.