28 October 2016 IRS official explains new position on tax treatment of certain contract termination fees The IRS recently reversed its position on the appropriate tax treatment of certain contract termination fees, in large part due to feedback on the Service's prior stance, an IRS official told attendees at a Practising Law Institute (PLI) conference on October 20. (See "Explaining the IRS's Changed Thinking on Merger Termination Fees," by Amy S. Elliott, 2016 TNT 206-1.) In September 2016, the IRS published Legal Advice Issued by Field Attorneys (20163701F; see Tax Alert 2016-1616), concluding 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 concluded the loss is a capital loss. The taxpayer and a target company had entered into an agreement expressing their intent to merge by forming a new company to which they would become subsidiaries. The merger agreement 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. The taxpayer ultimately 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. In the memorandum, the IRS noted that: (1) stock of the target 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 payment of the break fee resulted in a capital loss under Section 1234A, the IRS concluded. In October 2016, the IRS published a legal memorandum (ILM 201642035; see Tax Alert 2016-1778) describing 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. In both situations, the corporate taxpayer contracted with a target to acquire the target's publicly traded stock. The bilateral contract required both parties to make their best efforts to pursue the merger and allowed the target to terminate the contract under certain circumstances, including getting a better offer. Ultimately, another unrelated entity made a higher offer, which the target accepted. Under the parties' contract, the target paid the taxpayer a $1-million termination fee. The two examples in the ILM showed how to calculate gain or loss by subtracting costs associated with pursuing the deal from the $1-million termination fee. The ILM notes that the target's stock would be a capital asset in the acquirer's hands after the acquisition. The contract imposed obligations on both parties and provided the acquirer with rights to the target's stock (upon the completed acquisition). The ILM analogized the termination fee to liquidated damages, as opposed to compensation for services, and concluded 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. The conclusion in these 2016 memoranda — that a termination fee results in capital, rather than ordinary, gain or loss — contrasts with the IRS's conclusion in a 2008 private letter ruling (PLR 200823012; see Tax Alert 2008-862). In the PLR, two parties entered into a contract, agreeing to use their best efforts to take a series of steps that were designed to lead to the taxpayer's acquisition of the other party's (B) stock. B terminated the contract after receiving a superior offer from C and paid the taxpayer a termination fee, in keeping with their agreement. The IRS focused largely on the origin-of-the-claim doctrine, and ruled that the 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 ruled that that Section 1234A did not apply to treat the termination fee as capital gain. In TAM 200438038, the IRS reached largely the same conclusion. In US Freight Co. v. United States, 422 F.2d 887 (Ct. Cl. 1970), plaintiff US Freight had contracted to acquire the stock of a shipping company directly from the company's shareholder, made an advance payment under the contract, and rescinded the offer before the deal closed. The would-be seller retained the advance payment as liquidated damages, and US Freight claimed the amount as an ordinary loss on its federal income tax return. The government disallowed the deduction and US Freight sued for refund. The Claims Court held that forfeiture of a down payment as liquidated damages did not amount to the sale or exchange of a capital asset and therefore could be claimed as an ordinary loss. In the legislative history to Section 1234A, Congress indicated that Section 1234A was intended to overrule the result in the US Freight case1 and treat the loss on the forfeiture of the advance payment as capital. Speaking at the PLI conference, Helen Hubbard, IRS associate chief counsel (Financial Institutions and Products), reportedly sought to explain the shift in the IRS's perspective with regard to whether a contract termination fee should be considered capital or ordinary. She explained that the "'thinking at the time [the 2008 PLR was drafted was that] to have a right or an obligation be in line with U.S. Freight, you needed to actually have a contract with somebody who was going to sell you the property — the shareholders.'" Following the 2008 PLR, the IRS "'received a lot of criticism'" and was "pushed hard to reconsider [the conclusion reached in the 2008 PLR] and its 'wooden reading of U.S. Freight,'" according to Hubbard. "'In looking at it again,'" she reported, the IRS "'concluded it was not an obvious error — that there were arguments on both sides — but that the better answer was that the acquirer did have rights with respect to target stock as a result of the agreement with target and that what the acquirer was being compensated for in the termination fee was attributable to those rights with respect to the target stock.'" The IRS published the 2016 ILM to communicate this change, she indicated. If, on the other hand, one party incurs fees intending to acquire the stock of another but no right or obligation to the stock yet exists, "'and if you don't get to the point of a right or an obligation, we wouldn't say [Section] 1234A applies,'" Hubbard added. Hubbard specifically noted that the IRS interprets Example 4 (iv) in Treas. Reg. 1.263(a)-5(l), which provides that "inherently facilitative amounts … paid to determine the value of [the targets] may be recovered under section 165," results in an ordinary loss. In that example, the facts did not rise to level of having a right or obligation with respect to stock. Hubbard noted that whether the taxpayer or the IRS benefits from treating an item as producing a capital loss or an ordinary loss depends on the circumstances. The "result 'goes both ways because sometimes it works in the taxpayer's favor, which is why I think people were pressuring us to come to a different conclusion from the 2008 conclusion,'" she stated. The discussion at the PLI conference confirms that the IRS no longer follows the rationale of PLR 200823012 and views termination fees paid by or received by an acquirer as subject to Section 1234A. In addition, the IRS is of the view that losses from capitalized transaction costs related to an abandoned transaction are also subject to Section 1234A. Although not specifically discussed in the Tax Notes Today article, Hubbard expressed the view that Section 1234A applies to capitalized transaction costs even in situations where a termination fee is not paid. Although Hubbard made clear that Section 1234A applies to the acquirer's capitalized transaction costs only if the transaction has progressed to the point where there this a right or obligation with respect to a capital asset, there is uncertainty as to when the parties would be considered to have the requisite right or obligation. It is clear that an executed contract to acquire stock constitutes a right or obligation. However, prior to the execution of an agreement, the parties often enter into letters of intent or exclusivity agreements. It is uncertain whether the IRS would consider these types of documents as rising to the level of a right or obligation with respect to stock.
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