2016 year-end tax letter: Deduction of fee paid to terminate merger agreement limited by capital loss rules

In Legal Advice Issued by Field Attorneys (LAFA) 20163701F, the IRS concluded that the taxpayer’s loss arising from the payment of a “break fee” paid to terminate a stock acquisition agreement was incurred in connection with a capital asset (i.e., stock). Consequently, the loss is capital in nature and may be deducted by a corporate taxpayer only to the extent of capital gains and any excess loss carried over for a limited period.

Facts of the LAFA

According to the heavily redacted LAFA, the taxpayer entered into a merger agreement to acquire stock of a target entity. Under the agreement, the merger was conditioned upon the taxpayer’s board recommending the merger to its shareholders and, in the event the taxpayer withdrew its recommendation for the merger, the taxpayer was required to pay a break fee to the target. Before the transaction could be consummated, the U.S. Treasury Department issued a notice that adversely affected the expected tax benefits of the proposed merger and the taxpayer then withdrew its recommendation for the merger. The taxpayer and target subsequently entered into a termination agreement that obligated the taxpayer to pay the target the specified break fee, which constituted the target’s sole and exclusive remedy for the terminated merger.

Transaction costs rules – abandoned transactions

Transaction costs incurred in connection with an abandoned transaction, including payments to terminate a transaction, may generally be recovered.

Losses – general rules

Uncompensated losses sustained during the taxable year can be allowed as a deduction under the tax code. Capital losses are subject to certain limitations, for example, in the case of a corporation, losses from sales or exchanges of capital assets are limited to gains from such sales or exchanges. Excess capital losses can be carried over.

Capital assets defined

A capital gain or loss is gain or loss from the sale or exchange of a capital asset, which is defined as any property held by the taxpayer, regardless of whether it is connected to the taxpayer’s trade or business (unless it meets an exception). Stock is generally considered a capital asset.

Gains or losses from certain terminations

Gains and losses from certain terminations between capital assets and the taxpayer will be treated as gains and losses from the sale of a capital asset. These terminations include cancellations, lapses, expirations, or other rights and obligations (except for securities futures contracts).

Break fee loss is capital; deduction is limited

The IRS determined that under the terms of the merger and termination agreements, the break fee was paid in connection with the acquisition of stock, the merger agreement provided the taxpayer with rights and obligations with respect to the target’s stock, and that the break fee constituted liquidated damages pertaining to the stock transaction rather than compensation for services. Consequently, because stock is a capital asset, the IRS concluded that payment of the termination (break) fee, realized by the taxpayer in connection with cancelling the stock acquisition agreement, should be classified as capital in nature. Since the taxpayer is a corporation, deduction of the capital loss is limited to the amount of capital gains, with any excess carried over for a limited period (generally, three years back and five years forward).

Implications

This LAFA serves as an important reminder to take transaction costs, including significant contingent amounts such as termination or break fees, into account when structuring and planning mergers and acquisitions. Had the transaction in the LAFA been structured as an asset acquisition rather than a stock sale, it is possible all or a significant portion of the break-fee loss may have been classified as ordinary and currently deductible, depending on the facts (e.g., nature of the assets transferred, taxable income available to absorb the loss). Additionally, the LAFA highlights the need to carefully review the rules governing the treatment of transaction costs. While tax treatment of transaction costs should not be the sole or primary consideration when structuring mergers and acquisitions, the ability to deduct or accelerate the deduction of transaction costs is often a key negotiating point between the parties when the amounts involved are significant. To that end, although it may not be used or cited as precedent, this LAFA provides helpful insight to taxpayers planning or negotiating merger and acquisition transactions as to how the IRS applies to the rules on break fees paid in connection with an abandoned stock acquisition transaction.

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The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely.  The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.