Sec. 1234A and Termination Fees

Editor: Greg A. Fairbanks, J.D., LL.M.

It is not uncommon for the parties to a merger or acquisition agreement to terminate the transaction before it is consummated. In such an event, the party that breaches or otherwise terminates the agreement may forfeit a deposit or pay the other party a fee to terminate the agreement. The tax treatment of gain or loss from a terminated merger or acquisition was the subject of recent developments, including IRS guidance that contradicts its past conclusions. This item provides a brief history of existing tax law and IRS guidance and a summary of the recent developments.

U.S. Freight

In 1970, the Court of Claims in U.S. Freight Co., 422 F.2d 887 (Ct. Cl. 1970), held that a corporation’s termination of a contract to purchase stock resulted in an ordinary loss under Sec. 165(a).

In U.S. Freight, a corporation (U.S. Freight) entered into a contract to purchase stock from Josephine Bay Paul and her husband. The contract required U.S. Freight to pay $500,000 to the Pauls as a down payment that U.S. Freight would forfeit if it defaulted on its performance under the contract. U.S. Freight’s board of directors decided not to proceed with the purchase of stock from the Pauls.

U.S. Freight claimed an ordinary deduction of $500,000 on its tax return, but the IRS claimed that the amount should be a capital loss resulting from the sale or exchange of a capital asset.

The court held that U.S. Freight should treat the loss as an ordinary loss under Sec. 165(a). The court dismissed the IRS’s claim that the loss should be a capital loss, because there was no sale or exchange of a capital asset by U.S. Freight. The court stated that “where a contract to purchase property is unilaterally breached by the buyer, the right to purchase being thereby relinquished, and the down payment is forfeited as liquidated damages, we perceive no sale or exchange in the traditional sense” (U.S. Freight, 422 F.2d at 892).

However, the court in U.S. Freight reserved judgment for a different treatment in the event that the contractual right to purchase stock were actually sold or exchanged. The court stated, “This is not to say, however, that where on other facts a contract right is sold or exchanged, the nature of the property underlying the contract and the context in which it exists should not be considered in determining whether the contract right constitutes a capital asset” (U.S. Freight,422 F.2d at 893, fn. 4) (emphases in original).

Sec. 1234A

Sec. 1234A requires taxpayers to treat gain or loss related to the cancellation, lapse, expiration, or other termination of a right or obligation (other than a securities futures contract as defined in Sec. 1234B) with respect to property as gain or loss from a sale of a capital asset if that property is (or would be) a capital asset in the hands of the taxpayer.

Congress enacted Sec. 1234A in 1981, but originally it applied solely to “actively traded personal property.” In 1997, Congress extended Sec. 1234A’s scope to include all types of property, contemplating the application of Sec. 1234A to circumstances similar to those of U.S. Freight. The legislative history of the extension of Sec. 1234A includes a committee report that stated:

The Act extends to all types of property that is a capital asset in the hands of the taxpayer [the rule under Sec. 1234A]. . . . Thus, the extension of . . . section 1234A to all property that is a capital asset in the hands of the taxpayer affects capital assets that are (1) interests in real property and (2) non-actively traded personal property. . . . An example of the second type of property interest that is affected by the Act is the forfeiture of a down payment under a contract to purchase stock. [Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in 1997 (JCS-23-97), pp. 188—189 (Dec. 17, 1997)]

IRS Guidance

The IRS issued final regulations under Regs. Sec. 1.263(a)-5 on Dec. 31, 2003, which require taxpayers to capitalize amounts paid to facilitate certain transactions (T.D. 9107). While a comprehensive summary of Regs. Sec. 1.263(a)-5 is outside the scope of this item, an amount paid to terminate (or facilitate the termination of) an agreement to enter into a transaction under Regs. Sec. 1.263(a)-5 (an abandoned transaction) must be capitalized if it is related to another transaction under Regs. Sec. 1.263(a)-5 (the successful transaction) and the abandoned transaction and the successful transaction are mutually exclusive (Regs. Sec. 1.263(a)-5(c)(8)).

Notably, after the expansion of Sec. 1234A in 1997, the IRS issued guidance related to the recipient of a termination fee related to a merger agreement.

First, the IRS concluded in Technical Advice Memorandum (TAM) 200438038 that a termination fee resulted in ordinary income when it was received by the would-be acquirer in a failed merger agreement from the ultimate acquirer. In TAM 200438038, a corporation (Taxpayer) entered into a merger agreement to acquire the stock of another corporation (B) for stock, cash, and the assumption of debt. The merger agreement prohibited B from soliciting other offers, but B was permitted to consider and accept superior unsolicited offers. B was required to offer Taxpayer an opportunity to meet or beat a superior offer within five days. If B accepted the superior offer, it had to pay a termination fee to Taxpayer.

Subsequent to the merger agreement, B accepted an offer to be acquired by another party (C), and Taxpayer agreed to withdraw from the merger agreement upon receiving the termination fee. C paid the termination fee to Taxpayer.

Taxpayer initially claimed that the termination fee should be capital gain but then filed for a refund based on the argument that it represented damages to goodwill and should be a return of capital (i.e., includible in income only to the extent it exceeds its basis in property). However, the IRS concluded that the termination fee was ordinary income to Taxpayer because it provided for the recovery of lost profits. The IRS noted that the merger agreement did not specifically allocate the termination fee to either lost profits or damage to capital but that the termination fee should be treated as lost profits when its status is unclear or no allocation was made.

Subsequent to TAM 200438038, the IRS ruled in Letter Ruling 200823012 that a termination fee was treated as ordinary income when it was received by the would-be acquirer in an abandoned merger transaction from the target.

In Letter Ruling 200823012, a corporation (Taxpayer) entered into an agreement with another corporation (B) to take a series of steps designed to lead to Taxpayer’s acquisition of the stock of B for cash and a specified number of Taxpayer shares.

Taxpayer and B were publicly traded corporations, and the proposed acquisition was subject to a number of conditions, including approval by the shareholders of Taxpayer and B. Both parties had a right to terminate the agreement under certain circumstances (e.g., failure to obtain respective shareholder approval), but such a termination gave rise to an obligation to pay termination fees to the other party. B agreed not to solicit other offers but had the right to terminate the agreement if it received a superior unsolicited bid.

Subsequent to entering into the agreement, B received a superior offer to be acquired by another party. Because it became clear that B’s shareholders would not approve Taxpayer’s acquisition of B, B and Taxpayer entered into a new agreement to terminate the agreement. The new agreement included the same provisions that required B to pay termination fees to Taxpayer. B paid the termination fees to Taxpayer as stipulated in the new agreement.

The IRS ruled that the termination fees paid by B to Taxpayer were ordinary income to Taxpayer because the termination fees were equated to lost profits. Similar to TAM 200438038, the agreement did not specifically allocate the termination fee to either lost profits or damage to capital.

In addition, the IRS went one step further in Letter Ruling 200823012 by concluding that Sec. 1234A did not apply to the termination fees, but it did not provide any analysis of that conclusion.

CRI-Leslie, LLC

The Tax Court in CRI-Leslie, LLC, 147 T.C. No. 8 (2016), held that a forfeited deposit received by a partnership from a canceled sale of real property was ordinary income.

In CRI-Leslie, a partnership (CRI-Leslie) owned and operated a real estate property that included a hotel, restaurant, swimming pool, parking lot, and landscaping. The property constituted real property used in CRI-Leslie’s hotel and restaurant business under Sec. 1221(a)(2) and property used in its trade or business under Sec. 1231.

CRI-Leslie entered into an agreement to sell the property to RPS LLC in exchange for $39.2 million. RPS paid a $9.7 million deposit to CRI-Leslie in connection with the sale agreement. The deposit would have been applied to the property’s purchase price upon the closing of the sale.

RPS did not close on the purchase of the property from CRI-Leslie, and the agreement terminated pursuant to its terms. Because RPS defaulted on the agreement, RPS forfeited the deposit to CRI-Leslie.

CRI-Leslie reported $9.7 million of long-term capital gain on its tax return related to the deposit, arguing that the deposit should be treated as long-term capital gain under Sec. 1234A. However, the IRS took the position that CRI-Leslie should treat the forfeited deposit as ordinary income.

The parties stipulated that CRI-Leslie would have had “net Sec. 1231 gain” related to the property had it actually sold the property under the sale agreement. Such net Sec. 1231 gain would have been treated as long-term capital gain under Sec. 1231(a)(1). The sole issue decided by the court in CRI-Leslie was whether the term “capital asset” as used in Sec. 1234A included property described in Sec. 1231.

The court held that CRI-Leslie’s gain from the forfeited deposits should constitute ordinary income because Sec. 1234A specifically refers to “a capital asset in the hands of the taxpayer,” and Sec. 1221(a)(2) provides that the property was not a capital asset in the hands of CRI-Leslie.

The court also compared the plain wording of Sec. 1234A (“a capital asset in the hands of the taxpayer”) with the wording of other provisions. Specifically, Sec. 1234 provides that specified gain or loss related to an option to buy or sell property is treated as a sale or exchange of property with the same character as the underlying property in the hands of (or that would be in the hands of) the taxpayer (see alsoSec. 1234B).

The court stated:

We find it telling that the statute does not read: “property which has the same character as the property to which the * * * [right or obligation] relates has in the hands of the taxpayer (or would have in the hands of the taxpayer if acquired by him).” . . . Had Congress intended to cover section 1231 property under section 1234A, Congress could have, and likely would have, used wording parallel to that in sections 1234 and 1234B. The clarity of congressional purpose in restricting the reach of the statute to capital assets is ineluctable. [CRI-Leslie, LLC, slip op.at 18—19]

FAA 20163701F and CCA 201642035

The IRS has also issued recent guidance regarding the applicability of Sec. 1234A to termination fees.

First, the IRS concluded in Field Attorney Advice (FAA) 20163701F that a breakup fee related to the termination of a merger agreement resulted in a capital loss to a taxpayer under Sec. 1234A when it was paid by the acquirer. In FAA 20163701F, the taxpayer (TP) entered into a merger agreement to combine TP and another company (Target). To facilitate the merger, TP formed a new corporation (Newco). Taxpayer and Target would both become subsidiaries of Newco, with Newco’s stock being listed on an exchange. The merger was predicated upon TP’s board’s recommending the merger to its shareholders.

Before the merger could be consummated, the Treasury Department issued a notice that adversely affected the expected tax benefits of the merger, so TP withdrew its recommendation for the merger, upon which TP was required to pay a fee to Target. TP and Target entered into another agreement to terminate the merger agreement, which had provided that TP would pay Target the breakup fee. TP actually paid the breakup fee, which was Target’s sole and exclusive remedy for the terminated merger.

The IRS concluded in FAA 20163701F that TP’s loss arising from the payment of the breakup fee was a capital loss under Sec. 1234A. The IRS asserted that TP and Target had entered into an agreement in which each would acquire stock, which would be a capital asset in TP’s hands. In addition, the merger agreement provided a list of obligations that TP and Target would undertake to effectuate the merger. Thus, the IRS concluded that the merger agreement provided TP with rights and obligations with respect to Target’s and Newco’s stock, and the termination of the merger agreement was subject to Sec. 1234A.

Separately, the IRS concluded in Chief Counsel Advice (CCA) 201642035 that a termination fee resulted in capital gain or loss under Sec. 1234A when it was received by a corporation that would have been the acquirer in a failed merger. In CCA 201642035, a corporation (Acquirer) entered into an agreement with another corporation (T), which provided that both parties agreed to undertake a series of steps toward Acquirer’s acquisition of T’s stock. At the time the contract was entered, T’s stock was publicly traded.

The contract was a bilateral agreement that required both Acquirer and T to pursue a plan of merger and make their best efforts to effectuate Acquirer’s proposed acquisition of T stock, including that Acquirer and T would recommend the deal to their respective shareholders and would eachobtain the required governmental approvals.

The contract provided that T could terminate the agreement upon certain circumstances, but T was required to pay a $1 million termination fee to Acquirer upon such a termination. The terminating circumstances included: (1) T’s entering into another agreement based on a superior offer, (2) a rejection of Acquirer’s offer by T’s shareholders, or (3) a failure to obtain approval of T’s shareholders by a certain date.

T received a superior offer from another party and entered into an agreement with that party. As a result, T terminated the contract and paid Acquirer the termination fee of $1 million.

The IRS contemplated two scenarios in the CCA: (Situation 1) Acquirer incurred $200,000 of facilitative costs related to its proposed acquisition of the T stock that were required to be capitalized under Regs. Sec. 1.263(a)-5; and (Situation 2) Acquirer incurred $1.1 million of such costs required to be capitalized under Regs. Sec. 1.263(a)-5.

The IRS concluded that the termination fee gave rise to capital gain or loss to the acquirer under Sec. 1234A in both situations. The IRS asserted in both scenarios that T’s stock would have been a capital asset in Acquirer’s hands. Therefore, Sec. 1234A applied because the agreement provided Acquirer rights with respect to T’s stock.

In Situation 1, the IRS concluded that Acquirer’s amount realized from the receipt of the termination fee, $1 million, was reduced by Acquirer’s facilitative costs, $200,000. Thus, Acquirer had a capital gain of $800,000.

In Situation 2, the IRS concluded that Acquirer’s amount realized from the receipt of the termination fee, $1 million, was reduced by Acquirer’s facilitative costs, $1.1 million, resulting in a loss of $100,000. Thus, Acquirer had a capital loss of $100,000.

Commentary

The recent developments related to termination fees provide some interesting issues for practitioners to consider.

First, the facts in U.S. Freight and CRI-Leslie are similar because they each involve a forfeiture of a deposit. Sec. 1234A would seem to apply to the facts in U.S. Freight, based on the legislative history of Sec. 1234A, had Sec. 1234A been enacted in its current form; however, Sec. 1234A is not applicable to CRI-Leslie because the property was not a capital asset in the hands of the would-be seller. Given that the applicability of Sec. 1234A is determined by the character of the underlying property in the hands of the respective taxpayer, it may be possible that Sec. 1234A applies to the payer of a termination fee but not the recipient, or vice versa.

Furthermore, it may be possible that Sec. 1234A could apply partially to a right or obligation with respect to more than one property. For example, if a contract provides a right or obligation to acquire or sell more than one property, the underlying property may consist of both capital assets and noncapital assets in the taxpayer’s hands. Thus, Sec. 1234A may apply only to the extent that the underlying properties constitute (or would constitute) capital assets in the taxpayer’s hands.

In addition, the IRS conceded that its conclusion in CCA 201642035 reflects a different view than that of Letter Ruling 200823012. The IRS stated in footnote 1 of CCA 201642035, “We note that the conclusion in this memorandum is contrary to the conclusion reached on similar facts in [Letter Ruling] 200823012, which held without explanation that the receipt of a termination fee like that in Situation 1 resulted in ordinary income.”

It is noteworthy that the agreements in both CCA 201642035 and Letter Ruling 200823012 were entered into between the potential acquirer and the target, and not between the potential acquirer and the target’s shareholders. Still, the IRS stated in the CCA that the agreement provided the potential acquirer with rights and obligations with respect to the target’s stock because such an agreement is “a customary part of the process by which the stock of a publicly held corporation is acquired.” Thus, taxpayers and practitioners would be well-advised to carefully consider whether a right or obligation with respect to a capital asset exists in a similar circumstance.

The IRS was silent in CCA 201642035 as to whether Sec. 1234A applied to the payer (i.e., the target), but it may be conceivable that Regs. Sec. 1.263(a)-5(c)(8) would require the target to capitalize the termination fee under the facts in the CCA (see Regs. Sec. 1.263(a)-5(l), Example (13)). However, in a fact pattern without a mutually exclusive transaction, the target would need to have gain or loss attributable to a right or obligation with respect to a capital asset for Sec. 1234A to apply. In the facts of the CCA, the IRS stated that the target had obligations with respect to its own stock.

Finally, the determination of the gain or loss in CCA 201642035 takes into account amounts that were required to be capitalized under Regs. Sec. 1.263(a)-5. In particular, in Situation 2 of the CCA, the taxpayer’s facilitative costs that were capitalized under Regs. Sec. 1.263(a)-5 exceeded the termination fee, resulting in a capital loss under Sec. 1234A.

Whether this result is appropriate in all circumstances may be worth pondering further. For example, it is feasible that facilitative costs are required to be capitalized under Regs. Sec. 1.263(a)-5 before a right or obligation arises with respect to property. In such an instance, taxpayers may be compelled to argue that such facilitative costs should not be considered in determining gain or loss attributable to the termination of such a right or obligation under Sec. 1234A. This position appears to be contrary to the IRS’s position in CCA 201642035.

EditorNotes

Greg Fairbanks is a tax managing director with Grant Thornton LLP in Washington.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.