In a legal memorandum (ILM 201642035) the IRS describes two situations in which a corporate taxpayer realized either capital gain or capital loss after its planned merger with another company failed and the taxpayer received a termination fee under the parties' contract.

Background

In both situations, the corporate taxpayer (Acquirer) contracted with another company (Target) to acquire Target's stock, which was publicly traded. The bilateral contract required both parties to make their best efforts to pursue the merger and allowed Target to terminate the contract: if (1) another party made a superior offer and entered into a contract with Target; (2) Target's shareholders rejected Acquirer's offer; or (3) Target was unable to obtain approval from its shareholders by a certain date.

Ultimately, another unrelated entity made a higher offer, which Target accepted. Under its contract with Acquirer, Target paid a $1 million termination fee.

Situation 1. In Situation 1, Acquirer's costs associated with pursuing the deal with Target totaled $200,000. Acquirer properly capitalized these costs under Reg. Section 1.263(a)-5(e).

Situation 2. In Situation 2, Acquirer's costs associated with pursuing the deal with Target totaled $1.1 million, which Acquirer properly capitalized under Reg. Section 1.263(a)-5(e).

Law and analysis

Gain or loss that is attributable to the cancellation, lapse, expiration or other termination of a right or obligation with respect to a capital asset is treated as gain or loss from the sale of a capital asset (Section 1234A(1)). Expenses incurred and paid to investigate or otherwise pursue acquisitions are treated as capital expenditures (Reg. Section 1.263(a)-5(e)). Losses stemming from the sale or exchange of capital assets are limited to the amount of capital gains from other transactions (Section 1211), although excess losses may be carried over (Section 1212).

The ILM notes that, in both Situations 1 and 2, Target's stock would be a capital asset in Acquirer's hands after the acquisition. The contract between Acquirer and Target imposed obligations on both parties and provided Acquirer with rights to Target's stock (upon the completed acquisition). The ILM analogizes the termination fee to liquidated damages, as opposed to compensation for services, and concludes that "any gain or loss realized by Acquirer on the termination of the Contract, which provides rights and obligations with respect to Target's stock, a capital asset, would be capital in nature" under Section 1234A.

Therefore, the ILM concludes that Acquirer realized:

— A capital gain of $800,000 ($1m - $200,000) in Situation 1
— A capital loss of $100,000 ($1m - $1.1m) in Situation 2

In both situations, the IRS treated the capitalized transaction costs as an offset to the termination fee received in determining the amount of capital gain or loss.

Implications

In the ILM, the IRS clearly signals it no longer follows the rationale and conclusion in PLR 200823012,¹ which many taxpayers viewed as support for the position that Section 1234A did not apply to fees paid to terminate a contract to acquire stock. In Note 1 of ILM 201642035, the IRS states in relevant part that "[w]e note that the conclusion in this memorandum is contrary to the conclusion reached on similar facts in PLR 200823012." The holding in the ILM is also consistent with the holding in Legal Advice Issued by Field Attorneys (20163701F) (see Tax Alert 2016-1616), which held that a break fee paid to terminate a merger agreement resulted in a capital loss.

Implicit in the holdings of the ILM is that Section 1234A also applies to losses arising from capitalized costs of abandoned transactions. While the ILM treats the capitalized transaction costs as an offset to the termination fee (effectively treating it as a capital loss), treatment as a capital loss could arguably extend to situations in which a termination fee is not paid. This treatment of capitalized transaction costs reflects a broad application of Section 1234A and is contrary to the approach by many taxpayers, which claimed an ordinary deduction under Section 165 for capitalized transaction costs, even when a termination fee was paid. Capitalized transaction costs of an acquiring corporation are typically capitalized into the basis of the acquired stock only when the transaction is consummated.² There is no authority that specifically addresses how capitalized transaction costs are treated prior to the consummation of the transaction, including whether they are capitalized into the contract or other right to acquire stock. Based on the weight of existing authority, many taxpayers were of the view that the capitalized costs of a potential acquirer were treated as a separate unamortizable intangible until the transaction was consummated or terminated. In addition, unlike a termination fee, the capitalized transaction costs would have been incurred whether or not the transaction was terminated.

It should be noted that the existence of a right or obligation with respect to a capital asset (e.g., stock) is a prerequisite for the application of Section 1234A. Consequently, if a stock acquisition transaction is abandoned prior to the execution of a contract giving rise to a right or obligation, the capitalized transaction costs would presumably result in an ordinary deduction under Section 165. Query whether the execution of a stock purchase agreement ought to create a distinction in the character of losses from capitalized transaction costs.

———————————————

———————————————
ENDNOTES

¹ 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. The IRS also held that that Section 1234A did not apply to treat the termination fee as capital gain.

² Reg. Section 1.263(a)-5(g)(2)(i).