Tax court rules on tax treatment of due diligence costs for a failed acquisition

The lower tax court of Baden-Württemberg has held that due diligence costs incurred in connection with a failed or unsuccessful acquisition of shares are fully deductible for tax purposes.

The lower tax court of Baden-Württemberg ruled in a recently published decision that due diligence costs incurred in connection with a failed or unsuccessful acquisition of shares are fully deductible for tax purposes (case reference: 10 K 5175/09).

The case involved a corporation that intended to acquire shares in a target entity. Based on the approval of the board of directors, a letter of intent was signed and due diligence carried out. As a result of the due diligence, however, the taxpayer (the corporation) decided not to acquire the target entity. All costs directly incurred in connection with the due diligence activities (e.g. financial and tax due diligence, legal documents) were recorded as expenses for German GAAP and tax purposes and thus reduced the GAAP profit and taxable income of the taxpayer in the relevant year.

The tax authorities challenged this treatment in a tax audit for 2002 arguing that such costs should have been accounted for as incidental acquisition costs in a first step, followed by a (nondeductible) extraordinary write-down as a result of the failed acquisition so that ultimately the taxable income would not have been reduced by these expenses.

Based on past case law, the tax treatment of due diligence costs (i.e. immediate deduction or capitalization) in acquisition scenarios should depend on whether the costs are incurred before or after the decision is made to acquire the shares. To date, the courts have not ruled on the treatment of acquisition expenses incurred in relation to a failed acquisition.

In its decision, the tax court discussed the arguments relating to this issue, concluding that costs incurred in connection with a failed acquisition of shares cannot be considered acquisition costs because the shares were not actually acquired. According to the court, incidental acquisition costs can only be accounted for at the level of the acquiring company if beneficial ownership in the target shares is transferred. As a result, the expenses incurred in the case should be treated as immediately deductible business expenses.

The rules applying to individual taxpayers were amended with effect from 2011, so that due diligence expenses in a similar cases may be subject to restrictions because a connection with (partially) tax-exempt dividend income or capital gains may be presumed if the taxpayer intends to generate dividend income or capital gains. However, it is unlikely that this rule would apply to corporate taxpayers since the rules governing corporate taxpayers were not changed.

The case is currently pending before the Federal Tax Court (case reference: I R 72/11).

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