How are due-diligence costs treated upon acquisition?

October 13, 2020

by a searcher from EMLYON Business School in London, UK

I am trying to understand what type of due-diligence costs can be recharged to the acquired entity when a traditional search fund is executing on its ultimate acquisition. Typically an acquiring entity is able to recharge due-diligence cost (FDD, legal DD and others) to the target. The search fund vehicle should therefore be able to recover some cost incurred during the search. If that’s right then can these costs and any outstanding funding left at the end of the search be used to fund the acquisition? Any views on this would be much appreciated.
Many thanks
Ben

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Reply by a professional
from Walsh College of Accountancy and Business Administration in Detroit, MI, USA

Generally under U.S. GAAP when Business Combination Accounting (ASC 805) applies all transaction costs are expensed. GAAP generally pushes all of the costs into the Target for accounting purposes but this does not mean they can go there for tax purposes. For tax purposes, it is more complicated and it depends on a lot of factors. First, where the costs go depends on how your acquisition is structured, the entity type of the target, and who benefited from the costs to name a few factors. After concluding on where the costs belong for tax purposes, you will apply the tax laws (generally, Treas. Reg###-###-#### a)-5 and Section(s) 195, ###-###-#### , as applicable). On an initial acquisition, substantially all of your acquisition costs will be capitalized to one or more of the following buckets 1) start-up costs, 2) the assets acquired (whether actual assets or the stock of target), 3) prepaid insurance, and 4) debt costs. Some of the costs capitalized can be depreciated or amortized based on the type of asset they are being capitalized to while others are not.

Reply by a professional
from New York University in Mexico City, CDMX, Mexico

Watch out: Depending on the jurisdiction such costs may not be tax deductible, and they might not be directly related to the core business of the target.

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