In Legal Advice Issued by Field Attorneys (20163701F), the IRS Large Business & International associate area counsel has concluded that Section 1234A applies to a taxpayer's loss that arose because the taxpayer paid a "break fee" to terminate a merger agreement. Accordingly, the Service also concluded the loss is a capital loss.

Background

The taxpayer and a target company entered into an agreement expressing their intent to merge by forming a new company to which they would become subsidiaries. The merger depended on the taxpayer's board of directors' recommending the merger to taxpayer's shareholders, among other conditions. The agreement also provided that the shareholders of both the taxpayer and target would receive a certain amount of stock and the taxpayer would pay the target a "break fee" if the taxpayer withdrew its recommendation for the merger.

Before the merger occurred, the IRS "issued a notice that adversely affected the expected tax benefits of the proposed merger." The taxpayer subsequently withdrew its recommendation for the merger and paid the target a break fee, in keeping with their agreement. The fee represented the target's sole remedy for the cancellation of the merger and was not compensation for services.

Law and analysis

A capital asset generally is any property held by a taxpayer, whether or not held in connection with the taxpayer's trade or business, unless the asset is listed in Section 1221(a). Generally, gain or loss attributed to the cancellation, lapse, expiration or other termination of a right or obligation "with respect to property which is (or an acquisition would be) a capital asset in the hands of a taxpayer" is treated as gain or loss from the sale of a capital asset (Section 1234A). The legislative history to Section 1234A indicates that Section 1234A applies to the termination of a contract to purchase stock.¹

In the memorandum, the IRS noted that: (1) stock received as a result of the merger would have been a capital asset in the taxpayer's hands; (2) the contract between the parties gave the taxpayer rights and obligations with regard to the stock; and (3) as the target's sole remedy, the break fee, "was in the nature of liquidated damages rather than as compensation for services." Because the break fee "relates to a contractual right and obligation concerning a capital asset," the taxpayer's obligation to pay the break fee amounted to a capital loss under Section 1234A, the IRS concluded.

Implications

The conclusion in the memorandum is difficult to reconcile with the IRS conclusion in PLR 200823012.² In PLR 200823012, Taxpayer and B entered into an agreement (Agreement 1) under which the parties agreed to use their best efforts to take a series of steps that were designed to lead to Taxpayer's acquisition of the stock of B. B terminated Agreement 1 because it received a superior offer from C. Under the terms of Agreement 1, B paid Taxpayer a termination fee. The IRS focused largely on the origin-of-the-claim doctrine, and held that Taxpayer recognized ordinary income upon receipt of the termination fee because the purpose of the termination fee was the recovery of lost profits.³ The IRS also held that that Section 1234A did not apply to treat the termination fee as capital gain.

Although PLR 200823012 involves the character of an item of income, Section 1234A applies to both gain and loss attributable to the cancellation, lapse, expiration or other termination of a right or obligation with respect to property. Arguably, any conclusions regarding the applicability of Section 1234A extends to both items of income and deduction. Consequently, many taxpayers believed that the rationale of PLR 2008230012 extended to deductions for termination fees paid by potential acquirers to terminate stock acquisition agreements. The memorandum creates uncertainty regarding the IRS position on the application of Section 1234A to such deductions.

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ENDNOTES

¹ See, e.g., S. Rep. No. 10533, 105th Cong., 1st Sess. 135 (1997) (stating that Section 1234A would apply to "the forfeiture of a down payment to acquire stock").

² (June 6, 2008); See Tax Alert 2008-862.

³ See also TAM 200438038 (Dec. 29, 2004) (holding that a termination fee paid by a target in connection with the termination of an agreement to acquire the target's stock was ordinary income because it represented recovery of lost profits; the IRS did not mention Section 1234A).