How are transaction costs treated for tax purposes?

In connection with the purchase and sale of companies, significant costs may be incurred for advisers, due diligence, and valuations. Many businesses are unsure whether these costs can be deducted directly, or whether they must be capitalized and only become deductible upon a subsequent realization. Incorrect classification can have adverse tax consequences, and the assessment must be made on a case-by-case basis for each individual cost. In this article, we outline which transaction costs are tax-deductible, which must be capitalized, and how the rules apply to acquisitions, disposals, mergers, and demergers. You will also find out what happens if a planned transaction does not go ahead.

In short: Costs relating to day-to-day operations – such as strategic planning, market research, and general industry assessments – can be deducted directly. Costs associated with a specific share transaction, such as due diligence and negotiations, must, however, as a rule, be capitalized and added to the acquisition cost of the shares. In the case of mergers and demergers, the general rule is the opposite: as these are regarded as business reorganizations, the costs are, in principle, directly tax-deductible.

What are transaction costs?

Transaction costs refer to costs incurred in connection with the purchase and sale of businesses and limited companies, as well as mergers, demergers, and other major business reorganizations. Some examples of such costs are:

• Due diligence (tax, legal and financial review of the target company)

• Legal and financial advisers

• Valuations

• Contract negotiations and drafting

• Prospectuses
  
  

Also read: Why and how to conduct a valuation of your company

Which costs are tax-deductible?

In the initial phase, costs incurred in mapping out sectors and potential acquisition targets may be regarded as relating to the company’s day-to-day operations. This means that costs relating to strategy, mapping, and assessments of target companies, which are not linked to a specific transaction, may be deducted directly.

Costs relating to analyses, due diligence and negotiations concerning a specific share transaction, on the other hand, will not be directly deductible. Instead, costs incurred in connection with a specific share transaction must be capitalized. The cost of a share purchase is added to the acquisition cost of the shares, and the costs of a share sale are deducted from the disposal value. This means that the subsequent calculation of capital gain will be lower upon realization. However, if the shares are covered by the exemption method, the capital gain on realization will not be taxable. From a tax perspective, it will therefore be advantageous if the cost is not capitalized but is instead deducted directly.

Costs incurred in a subsequent phase relating to integration, organization and marketing will normally also be directly tax-deductible. The same applies to subsequent ownership and operating costs associated with the parent company’s administration and financing of the subsidiary.

The timing of when the cost is incurred is a key factor in the assessment, but it is not decisive. It is the main purpose of the cost that is the key consideration. In practice, there are many costs associated with the transaction and day-to-day operations. If the same cost relates both to the share acquisition and to day-to-day operations, only the portion attributable to day-to-day operations is deductible. It is therefore necessary to allocate which costs are directly deductible and which costs must be capitalized.

The overview below summarizes the general rule:

What happens if the transaction does not go ahead?

Costs incurred in connection with the planned acquisition of a specific limited company will not be directly deductible even if the transaction does not go ahead. This is because the costs were incurred to acquire shares under the exemption method. If, on the other hand, the attempt relates to shares outside the exemption method, a right to deduction may apply.

Right to deduct costs relating to mergers and demergers

Costs incurred in connection with mergers and demergers are treated differently from acquisition and disposal costs. This is because a merger constitutes a reorganization of the business. Costs incurred in connection with reorganization are, in principle, directly deductible.

Costs incurred by the companies in connection with the merger – such as the assessment of merger partners, the preparation of a merger plan, valuations, consultancy, due diligence, and subsequent integration – may therefore, as a general rule, be deducted directly.

If the merger is part of an acquisition, a specific assessment must be made as to whether costs relating to analyses, consultancy, valuation, and due diligence are to be regarded as transaction costs that should be capitalized. This will be relevant if the shareholders of the transferring company sell their shares immediately before or after the merger.

Do you need help assessing the right to deduct transaction costs?

The tax treatment of transaction costs can be complex. Incorrect classification may have adverse tax consequences. The assessment must be made on a case-by-case basis, and it may therefore be advisable to involve a tax adviser early in the process. Please feel free to contact us for a no-obligation discussion.