In a letter released last week, the Internal Revenue Service said that a publicly-traded acquiring corporation can deduct amounts it paid to settle a class action securities litigation lawsuit against the target entity that was triggered by misstatements in the entity’s reported earnings.The ruling is directed only to the taxpayer requesting it and may not be used or cited as precedent.

According to the letter, generally, amounts paid to settle lawsuits are only deductible if the acts that led to the litigation were performed in the ordinary conduct of the taxpayer's business. However, if the litigation arises from a capital transaction, then the settlement costs and legal fees associated with such litigation are characterized as acquisition costs and must be capitalized.

However, some business expenses are not converted into capital expenditures because they have some connection to a capital transaction. In determining whether litigation costs are deductible expenses or capital expenditures, the courts and the agency have looked to the “origin of the claim.”

In the case examined by the IRS, under the origin of the claim test, the acquiring corporation argued that the costs of settling all the claims made against it and the target entity were attributable to the alleged fraud occurring during the defendants’ ordinary course business activities, and did not originate in the merger of the two companies or any other capital acquisition.

The letter is available at www.irs.gov/pub/irs-wd/0649011.pdf.

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