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In an IRS Office of Chief Counsel Legal Memorandum (CCA 202224010), released on June 17, 2022, the IRS concluded that termination fees paid by a taxpayer in two failed transactions should be treated as IRC Section 165 losses that are capital under IRC Section 1234A instead of business expenses under IRC Section 162.

Facts

According to the CCA, Taxpayer agreed to acquire Target and be subject to a termination fee if the transaction was terminated. Taxpayer and Target agreed to terminate the transaction due to impracticability, and Taxpayer paid the termination fee. Taxpayer simultaneously entered into an agreement with Buyer. This transaction was also subject to a termination fee if that agreement was terminated. The second transaction with Buyer ultimately failed and Taxpayer paid a termination fee to Buyer. Taxpayer reported both termination fees as ordinary business expense deductions under IRC Section 162 on its Form 1120, U.S. Corporation Income Tax Return.

IRS conclusion

In the CCA, the IRS analyzed whether the termination fees should be recharacterized as capital losses under IRC Sections 165 and 1234A. The IRS determined that:

• The termination of each transaction resulted in a loss under IRC Section 165, not a business expense under IRC Section 162.
• The IRC Section 263(a) regulations do not require termination fees to be deducted under IRC Section 162.
• Relevant case law does not require the IRS to accept Taxpayer's treatment of the termination fees as IRC Section 162 expenses.
• IRC Section 1234A applies to characterize the termination fees as capital losses because they are attributable to assets in the hands of Taxpayer.

Law and analysis

IRC Section 1234A

The IRS began its analysis by noting that the application of IRC Section 1234A is based on the plain reading of the statute, which creates four requirements for determining whether IRC Section 1234A applies to a transaction:

(1) Gain or loss is attributable to an extinguishing event (i.e., cancellation, lapse, expiration or other termination).

(2) That event extinguishes a contractual right or obligation.

(3) The contractual right or obligation concerns underlying property that is a capital asset in the taxpayer's hands (or would be a capital asset if the taxpayer acquired the property).

(4) A "with respect to" nexus or connection exists between the right or obligation and the underlying capital asset.

The IRS found that the agreements created contractual rights and obligations for Taxpayer, Target and Buyer. Further, the rights and obligations in those agreements were extinguished by events within the scope of IRC Section 1234A (the termination of the agreements) and the agreements' transaction-related expenses were attributable to the extinguishment events.

IRC Section 165 losses

The IRS determined that the termination fees were IRC Section 165 losses, stating that "the facilitative costs of mergers and other similar major corporate transactions, including acquisitions or dispositions of assets constituting a trade or business, are required to be capitalized." Thus, if an acquisition is terminated or abandoned, the facilitative costs are recovered as IRC Section 165 losses. The IRS cited Treas. Reg. Section 1.165-2(a), which allows a deduction under IRC Section 165(a) when:

• A loss is incurred in a business (or in a transaction entered into for profit).
• The loss arises from the sudden termination of the usefulness of nondepreciable property to that business (or transaction).
• The business (or transaction) is discontinued or the property is permanently discarded from use.

In addition, the IRS discussed the legislative history of IRC Section 1234A, noting that it "reflects Congress's assumption that the making of a payment to terminate contracts with respect to capital assets results in the requisite gain or loss to apply the statute." The IRS also referred to case law to support the notion that termination payments stemming from capital transactions are IRC Section 165 losses. The IRS relied on Santa Fe Pac. Gold Co. v. Commissioner (Santa Fe)¹ and United States v. Federated Dept. Stores, Inc. (Federated),² which held termination payments in failed "white knight" acquisitions were deductible under two IRC sections, specifically IRC Section 162 and IRC Section 165.

For these reasons, the IRS concluded that the transactions from which the termination payments originated were dispositions of property under IRC Section 1001 that gave rise to gain or loss and that Taxpayer could recover the termination payments under IRC Section 165.

IRC Section 263(a) regulations

Taxpayer specifically asserted that a fee paid to terminate a transaction was better viewed as a deductible expense under IRC Section 162, rather than a loss under IRC Section 165, because it is not required to be capitalized unless it was paid to engage in a second, mutually exclusive capital transaction. The IRS viewed this argument as inferring that the termination payments must be deductible under IRC Section 162 because they were not expressly capitalized under the IRC Section 263(a) regulations. The IRS determined that the IRC Section 263(a) regulations do not control whether the termination fees are IRC Section 162 business expenses or IRC Section 165 losses, or otherwise limit applying IRC Section 1234A to those losses. The IRS further discussed the examples under Treas. Reg. Section 1.263(a)-5(c)(8) and noted that they also do not address whether a paid termination fee is deductible under IRC Section 165 or IRC Section 162 when the requirements of Treas. Reg. Section 1.263(a)-5(c)(8) do not apply.

The IRS explained that IRC Section 263 and other IRC provisions that allow deductions are independent of one another in terms of application. Taxpayers that must capitalize an expenditure under IRC Section 263 can only "deduct (or otherwise account for) the expense when the terms of a Code section are satisfied (as is the case when a merger is terminated or abandoned allowing deduction of the capitalized expense as [an IRS Section] 165 loss)."

Case law pertaining to merger terminations and the origin-of-the-claim doctrine

The IRS disagreed with Taxpayer's reliance on Santa Fe and Federated to argue that the termination payments were IRC Section 162 business expenses. Although the courts in both cases found that the termination payments could be deducted under IRC Sections 162 or 165, the IRS distinguished those holdings from the present case. First, the IRS noted that the IRC Section 162 rationale in the cases (in which the termination payments were ordinary and necessary business expenses in the course of defending a business from an unwanted acquisition) did not apply. Next, the IRS explained that the present case concerned the application of IRC Section 1234A, which was not at issue in either Santa Fe or Federated. Finally, the IRS said that the courts in the cases upon which Taxpayer relied ultimately agreed with the IRS that a fee paid to terminate a proposed transaction generates a loss under IRC Section 165(a) when the transaction is abandoned altogether.

The IRS also disagreed with Taxpayer's claim that a deduction of the termination payments under IRC Section 162 was warranted because they were negotiated to compensate Target and Buyer for their transaction costs. The IRS explained that Taxpayer appeared to reference the origin-of-the-claim doctrine and United States v. Gilmore,³ where courts analyzed "the origin and character of the claim with respect to which an expense was incurred" to determine its tax consequences. The IRS noted that Taxpayer provided little evidence that the termination payments were solely intended to compensate Target and Buyer for their expenses; even if a portion of the payments were for that purpose, it did not change "the fact that Taxpayer paid the Termination Fees to dispose of its rights and obligations arising from capital transactions."

According to the CCA, a review of the relevant case law clearly supported the conclusion that the payments made to terminate the transactions in the present case constituted disposing of a capital transaction and generally created a loss.

Applying IRC Section 1234A to the IRC Section 165 losses resulting from termination of the transactions

In reaching its conclusions, the IRS returned to the four requirements necessary to determine whether IRC Section 1234A applies to a transaction:

• Gain or loss is attributable to an extinguishing event (i.e., cancellation, lapse, expiration or other termination).
• That event extinguishes a contractual right or obligation.
• The contractual right or obligation concerns underlying property that is a capital asset in the taxpayer's hands, or would be if acquired.
• A "with respect to" nexus or connection exists between the right or obligation and the underlying capital asset.

The IRS concluded that the first two requirements of IRC Section 1234A were satisfied because the agreements created contractual rights and obligations and the termination of those agreements resulted in the payment of the termination fees, which resulted in IRC Section 165 losses.

The IRS then concluded that the second two requirements were satisfied. According to the IRS, the transaction with Target was intended to qualify as a reorganization under IRC Section 368(a), which would result in an asset acquisition. Thus, the agreement provided Taxpayer with rights and obligations with respect to Target's assets. The IRS viewed the transaction with Buyer purely on its form — Taxpayer had rights and obligations to the business it wished to divest, which is a capital asset.

Applying IRC Section 1234A, the IRS concluded the following:

• Taxpayer's IRC Section 165 loss from the termination of the transaction with Target is treated as capital under IRC Section 1234A to the extent that loss is attributable to Target's property that would have been capital assets in Taxpayer's hands if Taxpayer had acquired it.
• Taxpayer's loss from the termination of the transaction with Buyer is treated as capital under IRC Section 1234A to the extent that loss is attributable to Taxpayer's capital assets that Taxpayer would have sold to Buyer if the transaction had been consummated.

For purposes of determining the character of loss from the agreements, the IRS required the termination payments to be allocated among the individual ordinary and capital assets based on their relative fair market values.

Implications

The IRS's analysis is significant in that it highlights two points of possible disagreement between the government and taxpayers while also taking a practical approach in the mechanics of applying IRC Section 1234A.

First, the IRS concluded that taxpayers should deduct termination payments under IRC Section 165 but did not definitively state why IRC Section 162 did not apply. The IRS noted that the cases upon which Taxpayer relied pre-dated the revisions to IRC Section 1234A. Because IRC Section 1234A only applies after determining that IRC Section 165 applies, the revisions to IRC Section 1234A presumably did not change the analysis as to whether an expense is more properly treated under IRC Sections 162 or 165, in the first instance. Although Treas. Reg. Section 1.263(a)-5(c)(8) does not, itself, determine whether an expense is properly treated under IRC Section 162 or IRC Section 165, the treatment of an expense as a capitalizable expense that gives rise to basis may be relevant because IRC Section 165 loss is allowed only to the extent of such basis. For example, Treas. Reg. Section 1.165-1(c) provides that "the amount of loss allowable as a deduction under [IRC S]ection 165(a) shall not exceed the amount prescribed by [Treas. Reg. Section] 1.1011-1 as the adjusted basis for determining the loss from the sale or other disposition of the property involved." Further, in its analysis of Santa Fe and Federated, the IRS noted that the courts believed the termination payments were deductible under both IRC Sections 162 and 165. In distinguishing why IRC Section 162 does not apply to the present case, the IRS explains that the courts in Santa Fe and Federated were reviewing termination payments that stemmed from costs incurred to defend a business from an unwanted takeover and were thus ordinary and necessary business expenditures. The CCA's analysis does not specifically address the interaction between IRC Section 162 and IRC Section 165.

Second, the IRS concluded that all transaction-related expenses fall under the purview of IRC Section 1234A. Although this is consistent with the IRS's view in ILM 201642035,⁴ the conclusion conflicts with views held by some practitioners. Several leading commentators have questioned the IRS position that transaction costs are within the purview of IRC Section 1234A based, in part, on the premise that transaction costs are typically paid for services rendered in connection with the abandoned transaction, and not a right or obligation with respect to property.⁵

Finally, after determining that IRC Section 1234A applies to the termination payments in question, the IRS notes that the amount of loss that is capital in nature depends on the makeup of the underlying ordinary and capital assets of the business. This seems appropriate from both a technical and policy perspective, but a similar approach to IRC Section 1234A in other contexts could prove challenging to implement. For example, if a taxpayer enters into an inflation swap based on the Consumer Price Index, would any gain or loss on that swap need to be bifurcated between capital and ordinary, in proportion to the underlying index related to capital assets (e.g., groceries) versus services (e.g., health care)? If so, would the determination be made at the time the swap is entered into, or at the time the gain is recognized?

This CCA makes clear that the IRS is heavily scrutinizing the deductibility of termination payments stemming from capital transactions. As such, taxpayers may want to consult with their tax advisors about property characterizing and documenting the treatment of termination payments.

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ENDNOTES

¹ 132 T.C. 240 (1990).

² 171 B.R. 603 (S.D. Ohio 1994).

³ 372 U.S. 39, 49 (1963).

⁴ In ILM 201643035, the IRS concluded that IRC Section 1234A applied to treat receipt of a termination fee as capital gain. Further, the IRS concluded that capitalized transaction costs reduced the amount of capital gain. This latter conclusion reflects the IRS view that IRC Section 1234A applies to transaction costs.

⁵ Ginsburg, Mergers Acquisitions, and Buyouts ¶203.3.; Carrington, Tax Accounting in Mergers and Acquisitions ¶603.