“We Could Have Had it All”
ABC has been looking for someone special for a long time. Suitors have come and gone. Some have been better than others. Some were non-starters. Then ABC meets a person that may be “the one.” As it turns out, that person has also been looking for someone.
After getting to know each other a bit, ABC decides that it may be time to open up to one another, with the implicit understanding, of course, that neither of them would ever hurt the other by sharing this information with anybody else.
In a few months’ time, that special someone indicates that they are interested in a long-term relationship, and ABC promises that it will not entertain “overtures” from others. Then, one day, the moment ABC has been waiting for finally comes. That special someone proposes a permanent relationship with ABC. They select a date to formalize their union and announce it to the world.
ABC couldn’t be happier, or so it thinks. Then someone new appears. ABC never expected to hear from anyone like this person, didn’t think they would ever be interested, but there they are. What’s more, they are offering ABC much more than any other suitor ever did.
Too good to turn down? You bet. The existing engagement has to be called off. But there’s a price to pay. ABC’s now-former suitor spent a lot of money in getting to the point where they agreed to unite with ABC. In the process, the former suitor (who has been burned before) also determined that there was a less-than remote possibility that ABC would walk away if another, “better” suitor came along. “I would never do that to you,” ABC said, and in that spirit, agreed not to hold itself out as being “available,” and also agreed to pay a break-up fee if it ever called off the engagement.
Every deal, whether from the perspective of the seller or the buyer, is about economics. Few items will impact the economics of a deal more immediately than taxes. The deal involves the receipt and transfer of value, with each party striving to maximize its economic return on the deal. The more taxes that a party to the deal pays as a result of the deal structure, the lower is the party’s economic return. The more slowly that a party recovers its investment in the deal – for example, through tax deductions, such as amortization – the more expensive the deal becomes.
But what happens if the deal does not close? The buyer may have retained accountants, attorneys, financial advisers, and appraisers to assist it in investigating the deal and in putting it together. These professionals are expensive. (Sometimes, you even have to pay them what they are worth.)
Many buyers will seek to protect themselves from a target that may suffer from the jitters, or that may get a better offer, by requiring that the target agree to pay a termination fee. The target will recognize the logic in this, at least from the buyer’s perspective, and will have to take it into account – as an additional cost that it or its new suitor will have to bear – in determining whether to walk away from the deal.
Whether the amount of this fee will fully reimburse the buyer for its expenditures will depend, in no small part, upon how it will be treated for tax purposes.
The IRS’s Office of Chief Counsel recently issued an advisory opinion in which it discussed how gain or loss would be determined by a buyer corporation (“Taxpayer”) that incurred expenses investigating the acquisition of a target corporation’s stock (“Target”). Taxpayer entered into an agreement (“Contract”) with Target that was designed to lead to Taxpayer’s acquisition of Target’s stock. The Contract also provided that Taxpayer would receive a fee in the event Target terminated the Contract.
The Contract required Taxpayer and Target to pursue a plan of merger to effectuate Taxpayer’s stock acquisition through a merger of a newly-formed, wholly-owned subsidiary of Taxpayer with and into Target, with Target as the surviving entity (a “reverse subsidiary merger” – often used where Target has many shareholders, some of whom may be less than cooperative).
Regarding Target’s obligations under the Contract, the Contract required Target to recommend to its shareholders that they approve the plan of merger subject, however, to the receipt of a superior offer. The Contract provided that Target may terminate the contract upon (i) entering into another agreement based on a superior offer, (ii) a rejection of Taxpayer’s offer by Target’s shareholders, or (iii) a failure to obtain approval of Target’s shareholders by a certain date. The Contract provided that in the event the Contract was terminated due to one of the foregoing, Target would have to pay a termination fee of $X to Taxpayer.
As it turned out, Target received a superior offer from another suitor and entered into an agreement with this other corporation. Target terminated the Contract and paid Taxpayer the $X termination fee. At the time the Contract was terminated, Taxpayer had incurred $Y of costs in the process of investigating and pursuing the transaction that Taxpayer capitalized as costs of facilitating the proposed transaction.
Before discussing the IRS’s opinion, let’s review the applicable capitalization rules.
Amounts that are paid in the process of investigating or otherwise pursuing certain acquisitive transactions – including a taxable acquisition of assets that constitute a trade or business or a taxable acquisition of an ownership interest in a business entity if, immediately after the acquisition, the acquiring taxpayer owns more than 50% of the equity of the business entity – are capitalized as costs of “facilitating” the transaction.
An amount is paid to facilitate an acquisitive transaction if the amount is paid in the process of investigating or otherwise pursuing the transaction. Whether an amount is paid in the process of investigating or pursuing the transaction is determined based on all of the facts and circumstances. In determining whether an amount is paid to facilitate a transaction, the fact that the amount would not have been paid but for the transaction is relevant, but is not determinative. An amount paid to determine the value or price of a transaction is an amount paid in the process of investigating or otherwise pursuing the transaction. Employee compensation, overhead, and other costs are treated as amounts that do not facilitate a transaction.
In general, an amount paid by a taxpayer in the process of investigating or otherwise pursuing a covered transaction facilitates the transaction only if the amount relates to activities performed on or after the earlier of –
(i) The date on which a letter of intent, exclusivity agreement, or similar written communication (other than a confidentiality agreement) is executed by the acquirer and the target; or
(ii) The date on which the material terms of the transaction (as tentatively agreed to by the acquirer and the target) are authorized or approved by the taxpayer’s board of directors, or the date on which the acquirer and the target execute a binding written contract reflecting the terms of the transaction.
Notwithstanding the general rule, an amount paid in the process of investigating or otherwise pursuing a covered transaction facilitates that transaction if the amount is “inherently facilitative”, regardless of whether the amount is paid for activities performed prior to the date determined above. An amount is inherently facilitative if the amount is paid for –
(i) Securing an appraisal or formal written evaluation;
(ii) Structuring the transaction, including obtaining tax advice on the structure;
(iii) Preparing and reviewing the documents that effectuate the transaction;
(iv) Obtaining regulatory approval;
(v) Obtaining shareholder approval; or
(vi) Conveying property between the parties.
In the case of a taxable asset or stock acquisition, an amount required to be capitalized by the acquirer is added to the basis of the acquired assets (in the case of a transaction that is treated as an acquisition of the target’s assets for federal income tax purposes) or the acquired stock (in the case of a transaction that is treated as an acquisition of the target stock for federal income tax purposes).
The IRS’s Opinion: Capital Gain or Loss?
The IRS explained that capital gain or loss is gain or loss that is realized from the sale or exchange of a capital asset.
Gain or loss, it stated, that is attributable to the cancellation, lapse, expiration or other termination of a right or obligation with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer is treated as gain or loss from the sale of a capital asset.
The Code allows as a deduction any uncompensated loss sustained by a taxpayer during the taxable year. The IRS noted, however, that capital losses are subject to certain limitations.
Specifically, in the case of a corporation, losses from sales or exchanges of capital assets are limited to gains from the sale or exchange of such assets. The IRS noted, however, that capital losses in excess of such gains are carried forward.
In the advisory opinion, the IRS determined that Target’s stock would have been a capital asset in Taxpayer’s hands upon acquisition. The Contract provided Taxpayer with a bundle of rights vis-a-vis Target that related to Taxpayer’s proposed acquisition of Target stock. Although the Contract was between Taxpayer and Target, rather than between Taxpayer and Target’s shareholders, a contract between the acquiring corporation and the target corporation, the IRS stated, is a customary part of the process by which the stock of a target corporation may be acquired. The Contract imposed obligations on both parties with respect to Target’s stock. The Contract also provided Taxpayer with rights with respect to Target’s stock.
The IRS determined that the termination fee payable to Taxpayer under the Contract was in the nature of liquidated damages. Thus, any gain or loss realized by Taxpayer on the termination of the Contract, which provided rights and obligations with respect to Target’s stock (a capital asset), would be capital in nature.
Based on the foregoing, the IRS concluded that Taxpayer’s amount realized from the receipt of the termination fee of $X should be reduced by Taxpayer’s capitalized facilitative costs of $Y.
Where the termination fee exceeded these costs, Taxpayer would have realized a gain. Because this gain would have been attributable to the termination of Taxpayer’s right with respect to Target’s stock, property that would have been a capital asset in Taxpayer’s hands, the gain would have been treated as a gain from the sale of a capital asset. Accordingly, Taxpayer would have realized a capital gain.
Where the termination fee was less than Taxpayer’s capitalized facilitative costs, Taxpayer would have realized a loss and, because this loss was attributable to the termination of Taxpayer’s right with respect to Target’s stock, property that would have been a capital asset in Taxpayer’s hands, the loss would be treated as a loss from the sale of a capital asset. Accordingly, Taxpayer would have a capital loss that Taxpayer may deduct, subject to certain limitations on capital losses.
Yes, I sound like a broken record (or CD or phone or notebook or whatever), but it bears repeating.
Every transfer of value in an acquisitive transaction will have economic and tax consequences. In order to ensure the desired economic result (after taxes), a party to the transaction has to consult its tax advisers regarding the tax consequences and the manner in which the transfer should be structured and/or characterized so as to generate the desired result. Armed with this knowledge, the party can then determine whether the appropriate amount of value is being paid or received.