when an agreed-upon merger or acquisition falls through. Buyers often incorporate language into purchase agreements that institute a termination fee the target company pays when such agreements aren’t consummated. Two rulings were issued that address the tax treatment of such termination fees.
On October 14, 2016, the IRS issued Chief Counsel Advice (CCA) 201642035, which included two examples of a company receiving a merger termination fee from a target company.
In the first example, the acquirer corporation (Acquirer) entered into an agreement with the target corporation (Target) to acquire Target’s stock. The contract allowed Target to terminate the transaction if Target and another party agreed to a superior offer, provided Acquirer was paid a $1 million termination fee.
When Target received and accepted a superior offer, the original contract was terminated and Acquirer received the $1 million termination fee. At the time of termination, Acquirer incurred $200,000 of costs related to investigating and pursuing the transaction. As these costs are facilitative to closing the transaction, the costs are capitalized for tax purposes.
As Target’s stock is considered a capital asset under Internal Revenue Code Section 1221, Capital Asset Defined, and the termination fee received is related to the termination of Acquirer’s right with respect to Target’s stock, the fee is considered a gain from the sale of a capital asset that is recognized by Acquirer within §1222, Other Terms Relating to Capital Gains and Losses, and §1234A, Gains or Losses From Certain Terminations. The gain is then reduced by the amount of facilitative costs paid for investigating and pursuing the transaction. For example one, this created an $800,000 capital gain ($1 million termination fee less the $200,000 in acquisition-related costs).
In the second example, the same facts as the first example were present except the costs related to investigating and pursuing the transaction totaled $1.1 million. These facilitative costs also were capitalized for tax purposes.
In this case, a $100,000 capital loss was generated ($1 million termination fee less the $1.1 million in acquisition-related costs).
On September 9, 2016, the IRS released Legal Advice Issued by Field Attorneys (LAFA) 20163701F. The publication’s purpose was to determine whether a merger termination fee leads to a capital loss within §1234A for an acquirer that entered into an agreement to acquire a target corporation.
While the facts are similar to the examples above, in this agreement the taxpayer would be required to pay a termination fee to the target corporation if the taxpayer withdrew from the merger. When the taxpayer withdrew from the merger after learning of a U.S. Treasury Department notice that would adversely affect the transaction’s anticipated tax benefits, it paid the termination fee per the agreement.
The LAFA concluded the termination fee resulted in a capital loss for the taxpayer under §1234A. This was due to the merger agreement giving the taxpayer the right to acquire stock in the target corporation.
Effect on C Corporations & Flow-Through Entities
In the event of a capital loss, the deductibility of that loss may be limited depending on multiple factors.
C corporations may deduct capital losses in the current year only to the extent of capital gains. If the loss cannot be deducted in the current year, the loss is carried back three years, then forward five years. If a capital gain isn’t recognized within that time, the capital loss expires along with the associated tax benefit.
Flow-through entities—such as S corporations and partnerships—have the opportunity to push the capital loss down to their shareholders or partners. In the case of any individual shareholders or partners, the capital loss that would flow through would be limited to a $3,000 deduction per taxable year, assuming no other capital gain/loss transactions occur.
It’s important to be aware of deduction limitations when analyzing the tax effect of termination fees. A company’s ability to plan for fees and manage any available capital gains can enhance the possibility that capital losses can be used in some form.
For more information on the publications and how the conclusions could affect your business decisions, contact your BKD advisor and take advantage of our Year-End Tax Advisor.