Capital loss rules limit deduction of fees paid to terminate merger agreement

Editor: Mark Heroux, J.D.

In Chief Counsel Advice (CCA) 202224010, the IRS concluded that termination fees and capitalized transaction expenses paid in connection with a terminated merger agreement were capital losses to the extent the merger property consisted of capital assets. Generally, such capital losses may only be deducted by a corporate taxpayer to the extent of capital gains, with any excess loss carried over or back for a limited period.

Facts of the CCA

According to the heavily redacted CCA, the taxpayer entered into a merger agreement to acquire the assets of a target entity in an “A reorganization” under Sec. 368(a)(1)(A). Under the arrangement, the taxpayer or target could terminate the agreement if the acquisition was not consummated by a specified date. In the event a termination was triggered and certain other circumstances existed, the taxpayer was required to pay the target a termination fee. Prior to completion of the transaction, the taxpayer and target agreed to terminate the merger agreement, and the taxpayer paid the termination fee to the target. Additionally, the taxpayer paid a second termination fee to another transaction party (buyer) pursuant to a separate agreement to terminate a contract for the sale of certain of the taxpayer’s assets. The taxpayer deducted the termination fees as ordinary Sec. 162 expenses on its Form 1120, U.S. Corporation Income Tax Return. On audit, the IRS sought to disallow the deductions and characterize all or part of the amounts as capital losses under Secs. 165 and 1234A.

The termination fees and capitalized transaction expenses were Sec. 165 losses

In the CCA, the IRS held that the termination of the agreements resulted in dispositions under Sec. 1001, which gave rise to losses under Sec. 165 rather than to business expenses under Sec. 162.

In support of its conclusion, the IRS cited multiple authorities that require a taxpayer’s facilitative costs to be recovered as Sec. 165 losses if an acquisition is terminated or abandoned (see Rev. Rul. 73-580; Regs. Sec. 1.263(a)-5(l), Examples (3) and (4); Santa Fe Pacific Gold Co., 132 T.C. 240 (2009); Federated Department Stores, Inc., 171 B.R. 603 (S.D. Ohio 1994); and A.E. Staley Manufacturing Co., 119 F.3d 482, 490–92 (7th Cir. 1997)).

Regs. Sec. 1.263(a)-5(a) generally requires capitalization of costs that facilitate capital transactions, including an acquisition of assets that constitute a trade or business. Significantly, the IRS noted that the regulations under Sec. 263(a) do not require or imply that transaction expenses are deductible as Sec. 162 expenses if they are not required to be capitalized under these regulations as facilitating the transaction. Rather, the taxpayer must look to other potentially applicable sections of the law to determine the appropriate treatment of the costs (e.g., capitalization provisions under Sec. 195, 263(g), 263(h), or 263A). Accordingly, the IRS rejected the taxpayer’s interpretation of the “mutual exclusivity” rule in Regs. Sec. 1.263(a)-5(c)(8). Under this rule, termination payments are generally required to be capitalized when paid to terminate an agreement so that a second, mutually exclusive capital transaction may be pursued.

The taxpayer argued that capitalization was not required and the payments were therefore deductible Sec. 162 expenses because there was no second, mutually exclusive transaction that caused the merger agreement to be terminated. In rejecting this interpretation of the rule, the IRS noted that the absence of a mutually exclusive transaction simply means that this particular rule does not apply, and the taxpayer must look to other provisions of the law to determine the treatment of termination payments.

Similarly, the CCA concluded that the Santa Fe and Federated cases cited by the taxpayer did not support treating the termination fee payments as deductible Sec. 162 business expenses under the taxpayer’s facts. According to the IRS, these cases do not address the key issue of whether the taxpayer’s termination payments were properly classified as losses versus expenses. Furthermore, the conclusion reached in these cases that the termination payments might be deductible Sec. 162 expenses was based on facts that did not apply to the taxpayer’s situation because the taxpayer’s fees were not ordinary and necessary business expenses of defending against unwanted attacks on the taxpayer’s trades or businesses (e.g., hostile takeover attempts).

Finally, the IRS determined that the taxpayer provided “little evidence” to support its claim that the termination payments were solely intended to compensate the parties for their transaction costs and were therefore Sec. 162 business expenses deductible under the “origin of the claim” doctrine established in Gilmore, 372 U.S. 39 (1963). The IRS consequently dismissed this argument and further noted that, even if a portion of the payment may have compensated the target for its transaction costs, this did not alter the fact that the taxpayer paid the termination fees to dispose of its rights and obligations arising from capital transactions, which brought the amounts within the scope of Sec. 1234A, discussed below.

The losses were capital under Sec. 1234A

The CCA summarized the requirements for a transaction to be subject to Sec. 1234A as:

• There is gain or loss attributable to an extinguishing event (i.e., cancellation, lapse, expiration, or other termination);
• That event extinguishes a contractual right or obligation;
• The contractual right or obligation concerns underlying property that is a capital asset in the taxpayer’s hands (or that would be a capital asset if the property were acquired by the taxpayer); and
• There is a “with respect to” nexus or connection between the right or obligation and the underlying capital asset.

As applied to the taxpayer’s facts, the CCA concluded that these “plain language” Sec. 1234A requirements were satisfied. Specifically, as indicated in the facts, the transaction agreements created contractual rights and obligations that were extinguished upon termination of those agreements. Pursuant to the authorities summarized above, the termination of those rights and obligations resulted in Sec. 165 losses equal to the termination fees and the capitalized expenses incurred to facilitate the transactions.

Furthermore, the extinguished contractual rights — and the Sec. 165 losses that resulted from them — pertained all or in part to assets that were or would have been capital in the taxpayer’s hands had the agreements not been terminated. Accordingly, the taxpayer’s Sec. 165 losses resulting from the termination of the transaction agreements were treated as capital under Sec. 1234A to the extent the losses were attributable to property that was or would have been capital assets in the taxpayer’s hands had the transactions been completed.

The amount of capital loss is determined by dividing the value of the property that was or would have been capital assets in the taxpayer’s hands by the total value of the property and then multiplying the loss by that fraction (see Watson, 345 U.S. 544 (1953), and Williams v. McGowan, 152 F.2d 570 (2d Cir. 1945)). Importantly, the CCA notes that, for purposes of applying Sec. 1234A, the term “capital asset” does not include certain trade or business property described in Sec. 1221(a)(2) even if the property is subject to Sec. 1231, which might shield a significant portion of the losses from potentially unfavorable capital loss treatment, depending on the taxpayer’s facts (see CRI-Leslie, LLC, 882 F.3d 1026 (11th Cir. 2018)).

Implications

This CCA serves as an important reminder to take transaction costs, including significant contingent amounts such as termination fees, into account when structuring and planning mergers and acquisitions. While the 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. Although it may not be used or cited as precedent, this CCA provides valuable insight to taxpayers planning or negotiating merger-and-acquisition transactions as to how the IRS applies the rules to termination fees paid in connection with an abandoned asset acquisition.

Significantly, the CCA confirms that a transaction structured as an asset acquisition may allow all or a significant portion of losses stemming from some transaction costs to be classified as ordinary and currently deductible, depending on the facts (e.g., the nature of the assets transferred and taxable income available to absorb the loss). Conversely, earlier guidance addressing the treatment of fees paid to terminate a stock acquisition agreement concluded that, because the payments were made in connection with a capital asset (i.e., stock), the entire loss was capital in nature and therefore subject to the capital loss limitation rules, which can significantly limit a corporate taxpayer’s loss deductions (see Legal Advice Issued by Field Attorneys 20163701F and CCA 201642035).

Editor Notes

Mark Heroux, J.D., is a tax principal in the Tax Advocacy and Controversy Services practice at Baker Tilly US, LLP in Chicago. Contributors are members of or associated with Baker Tilly US, LLP. For additional information about these items, contact Mr. Heroux at mark.heroux@bakertilly.com.