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August 8, 2022 US IRS concludes that termination fees in failed merger were capital losses
In an Internal Revenue Service (IRS) Office of Chief Counsel Legal Memorandum (CCA 202224010), released on 17 June 2022, the IRS concluded that termination fees paid by a taxpayer in two failed transactions should be treated as Internal Revenue Code1 (IRC) Section 165 losses that are capital under Section 1234A instead of business expenses under Section 162. Facts According to the CCA, Taxpayer agreed to acquire Target and be subject to a termination fee if the transaction was terminated. Taxpayer and Target agreed to terminate the transaction due to impracticability, and Taxpayer paid the termination fee. Taxpayer simultaneously entered into an agreement with Buyer. This transaction was also subject to a termination fee if that agreement was terminated. The second transaction with Buyer ultimately failed and Taxpayer paid a termination fee to Buyer. Taxpayer reported both termination fees as ordinary business expense deductions under Section 162 on its Form 1120, U.S. Corporation Income Tax Return. IRS conclusion In the CCA, the IRS analyzed whether the termination fees should be recharacterized as capital losses under Sections 165 and 1234A. The IRS determined that:
Law and analysis Section 1234A The IRS began its analysis by noting that the application of Section 1234A is based on the plain reading of the statute, which creates four requirements for determining whether Section 1234A applies to a transaction: (1) Gain or loss is attributable to an extinguishing event (i.e., cancellation, lapse, expiration or other termination). (2) That event extinguishes a contractual right or obligation. (3) The contractual right or obligation concerns underlying property that is a capital asset in the taxpayer's hands (or would be a capital asset if the taxpayer acquired the property). (4) A "with respect to" nexus or connection exists between the right or obligation and the underlying capital asset. The IRS found that the agreements created contractual rights and obligations for Taxpayer, Target and Buyer. Further, the rights and obligations in those agreements were extinguished by events within the scope of Section 1234A (the termination of the agreements) and the agreements' transaction-related expenses were attributable to the extinguishment events. Section 165 losses The IRS determined that the termination fees were Section 165 losses, stating that "the facilitative costs of mergers and other similar major corporate transactions, including acquisitions or dispositions of assets constituting a trade or business, are required to be capitalized." Thus, if an acquisition is terminated or abandoned, the facilitative costs are recovered as Section 165 losses. The IRS cited Treas. Reg. Section 1.165-2(a), which allows a deduction under Section 165(a) when:
In addition, the IRS discussed the legislative history of Section 1234A, noting that it "reflects Congress's assumption that the making of a payment to terminate contracts with respect to capital assets results in the requisite gain or loss to apply the statute." The IRS also referred to case law to support the notion that termination payments stemming from capital transactions are Section 165 losses. The IRS relied on Santa Fe Pac. Gold Co. v. Commissioner (Santa Fe)2 and United States v. Federated Dept. Stores, Inc. (Federated),3 which held termination payments in failed "white knight" acquisitions were deductible under two IRC sections, specifically Section 162 and Section 165. For these reasons, the IRS concluded that the transactions from which the termination payments originated were dispositions of property under Section 1001 that gave rise to gain or loss and that Taxpayer could recover the termination payments under Section 165. Section 263(a) regulations Taxpayer specifically asserted that a fee paid to terminate a transaction was better viewed as a deductible expense under Section 162, rather than a loss under Section 165, because it is not required to be capitalized unless it was paid to engage in a second, mutually exclusive capital transaction. The IRS viewed this argument as inferring that the termination payments must be deductible under Section 162 because they were not expressly capitalized under the Section 263(a) regulations. The IRS determined that the Section 263(a) regulations do not control whether the termination fees are Section 162 business expenses or Section 165 losses, or otherwise limit applying Section 1234A to those losses. The IRS further discussed the examples under Treas. Reg. Section 1.263(a)-5(c)(8) and noted that they also do not address whether a paid termination fee is deductible under Section 165 or Section 162 when the requirements of Treas. Reg. Section 1.263(a)-5(c)(8) do not apply. The IRS explained that Section 263 and other IRC provisions that allow deductions are independent of one another in terms of application. Taxpayers that must capitalize an expenditure under Section 263 can only "deduct (or otherwise account for) the expense when the terms of a Code section are satisfied (as is the case when a merger is terminated or abandoned allowing deduction of the capitalized expense as [an IRS Section] 165 loss).” Case law pertaining to merger terminations and the origin-of-the-claim doctrine The IRS disagreed with Taxpayer's reliance on Santa Fe and Federated to argue that the termination payments were Section 162 business expenses. Although the courts in both cases found that the termination payments could be deducted under Sections 162 or 165, the IRS distinguished those holdings from the present case. First, the IRS noted that the Section 162 rationale in the cases (in which the termination payments were ordinary and necessary business expenses in the course of defending a business from an unwanted acquisition) did not apply. Next, the IRS explained that the present case concerned the application of Section 1234A, which was not at issue in either Santa Fe or Federated. Finally, the IRS said that the courts in the cases upon which Taxpayer relied ultimately agreed with the IRS that a fee paid to terminate a proposed transaction generates a loss under Section 165(a) when the transaction is abandoned altogether. The IRS also disagreed with Taxpayer's claim that a deduction of the termination payments under Section 162 was warranted because they were negotiated to compensate Target and Buyer for their transaction costs. The IRS explained that Taxpayer appeared to reference the origin-of-the-claim doctrine and United States v. Gilmore,4 where courts analyzed "the origin and character of the claim with respect to which an expense was incurred" to determine its tax consequences. The IRS noted that Taxpayer provided little evidence that the termination payments were solely intended to compensate Target and Buyer for their expenses; even if a portion of the payments were for that purpose, it did not change "the fact that Taxpayer paid the Termination Fees to dispose of its rights and obligations arising from capital transactions." According to the CCA, a review of the relevant case law clearly supported the conclusion that the payments made to terminate the transactions in the present case constituted disposing of a capital transaction and generally created a loss. Applying Section 1234A to the Section 165 losses resulting from termination of the transactions In reaching its conclusions, the IRS returned to the four requirements necessary to determine whether Section 1234A applies to a transaction:
The IRS concluded that the first two requirements of Section 1234A were satisfied because the agreements created contractual rights and obligations and the termination of those agreements resulted in the payment of the termination fees, which resulted in Section 165 losses. The IRS then concluded that the second two requirements were satisfied. According to the IRS, the transaction with Target was intended to qualify as a reorganization under Section 368(a), which would result in an asset acquisition. Thus, the agreement provided Taxpayer with rights and obligations with respect to Target's assets. The IRS viewed the transaction with Buyer purely on its form — Taxpayer had rights and obligations to the business it wished to divest, which is a capital asset. Applying Section 1234A, the IRS concluded the following:
For purposes of determining the character of loss from the agreements, the IRS required the termination payments to be allocated among the individual ordinary and capital assets based on their relative fair market values. Implications The IRS's analysis is significant in that it highlights two points of possible disagreement between the Government and taxpayers while also taking a practical approach in the mechanics of applying Section 1234A. First, the IRS concluded that taxpayers should deduct termination payments under Section 165 but did not definitively state why Section 162 did not apply. The IRS noted that the cases upon which Taxpayer relied pre-dated the revisions to Section 1234A. Because Section 1234A only applies after determining that Section 165 applies, the revisions to Section 1234A presumably did not change the analysis as to whether an expense is more properly treated under Sections 162 or 165, in the first instance. Although Treas. Reg. Section 1.263(a)-5(c)(8) does not, itself, determine whether an expense is properly treated under Section 162 or Section 165, the treatment of an expense as a capitalizable expense that gives rise to basis may be relevant because Section 165 loss is allowed only to the extent of such basis. For example, Treas. Reg. Section 1.165-1(c) provides that "the amount of loss allowable as a deduction under [IRC S]ection 165(a) shall not exceed the amount prescribed by [Treas. Reg. Section] 1.1011-1 as the adjusted basis for determining the loss from the sale or other disposition of the property involved." Further, in its analysis of Santa Fe and Federated, the IRS noted that the courts believed the termination payments were deductible under both Sections 162 and 165. In distinguishing why Section 162 does not apply to the present case, the IRS explains that the courts in Santa Fe and Federated were reviewing termination payments that stemmed from costs incurred to defend a business from an unwanted takeover and were thus ordinary and necessary business expenditures. The CCA's analysis does not specifically address the interaction between Section 162 and Section 165. Second, the IRS concluded that all transaction-related expenses fall under the purview of Section 1234A. Although this is consistent with the IRS's view in ILM 201642035,5 the conclusion conflicts with views held by some practitioners. Several leading commentators have questioned the IRS position that transaction costs are within the purview of Section 1234A based, in part, on the premise that transaction costs are typically paid for services rendered in connection with the abandoned transaction, and not a right or obligation with respect to property.6 Finally, after determining that Section 1234A applies to the termination payments in question, the IRS notes that the amount of loss that is capital in nature depends on the makeup of the underlying ordinary and capital assets of the business. This seems appropriate from both a technical and policy perspective, but a similar approach to Section 1234A in other contexts could prove challenging to implement. For example, if a taxpayer enters into an inflation swap based on the Consumer Price Index, would any gain or loss on that swap need to be bifurcated between capital and ordinary, in proportion to the underlying index related to capital assets (e.g., groceries) versus services (e.g., health care)? If so, would the determination be made at the time the swap is entered into, or at the time the gain is recognized? This CCA makes clear that the IRS is heavily scrutinizing the deductibility of termination payments stemming from capital transactions. As such, taxpayers may want to consult with their tax advisors about property characterizing and documenting the treatment of termination payments. _________________________________________ For additional information with respect to this Alert, please contact the following: Ernst & Young LLP (United States), National Tax – Accounting Periods, Methods, and Credits
Ernst & Young LLP (United States), International Tax and Transaction Services
Ernst & Young LLP (United States), International Tax and Transaction Services – Capital Markets Tax Practice
_________________________________________ Endnotes
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