The US Tax Court (Court), in AbbVie Inc. and Subsidiaries v. Commissioner of Internal Revenue, 164 T.C. No. 10, held that a nearly $1.6 billion Break Fee (described further below) paid by AbbVie to Shire plc was properly deducted as an ordinary loss and not a capital loss under IRC Section 1234A, as the IRS had claimed.

Background

In 2014, AbbVie Inc. (AbbVie), a domestic public corporation, and Shire plc (Shire), a foreign public limited company, entered into an agreement to facilitate a proposed merger as part of an inversion transaction. Under the proposed structure, the stock of both AbbVie and Shire would be acquired by a newly formed corporation (Proposed Transaction). In connection with the Proposed Transaction, AbbVie and Shire entered into a co-operation agreement (Agreement), under which AbbVie agreed to pay Shire a break fee of $1.6 billion if AbbVie's board of directors failed to recommend the business combination to its shareholders. Additionally, as part of the Agreement, AbbVie agreed to (1) take the lead in securing regulatory approval of the Proposed Transaction and communicating with Shire about regulatory approvals, (2) work with Shire and its advisors to take all steps necessary to implement the Proposed Transaction, (3) recommend the Proposed Transaction to its shareholders, call a shareholder meeting for purposes of voting on the Proposed Transaction, and use best efforts to secure shareholder approval of the Proposed Transaction, and (4) provide information and documentation as required ahead of Shire's shareholder vote.

Following the release of adverse tax guidance from the Department of the Treasury, AbbVie's board chose not to recommend the merger, leading to the execution of a termination agreement and the payment of the Break Fee. AbbVie reported the Break Fee as an ordinary deduction on its 2014 tax return, but the IRS disallowed the deduction, asserting that it was not deductible as an expense under IRC Section 162 or as an ordinary loss under IRC Section 165 but that it instead should be treated as a capital loss under IRC Section 1234A.

The IRS issued AbbVie a Notice of Deficiency determining a deficiency of approximately $572 million as a result of treating the Break Fee as a capital loss rather than an ordinary loss.

Analysis and holding

IRC Section 1234A generally treats a gain or loss from the cancellation or termination of rights or obligations "with respect to property" that is or would be a capital asset as a capital gain or capital loss. The Court held in favor of AbbVie, concluding that the Break Fee did not constitute a capital loss under IRC Section 1234A, reasoning that AbbVie's rights and obligations under the agreement were fundamentally related to services rather than property. The Court found the essence of the agreement was to facilitate the merger, which involved obligations to secure regulatory approvals and recommend the merger to shareholders, rather than rights to buy or sell property. Specifically, the Court said, "Close consideration of the context here tells us that a right or obligation "with respect to property" within the meaning of [IRC] Section 1234A is a right or obligation to exchange (i.e., to buy, sell, or otherwise transfer or receive) an interest in property." By contrast, a right or obligation to perform services related to property or to otherwise act without such a transfer is not a "right or obligation … with respect to property" within the meaning of [IRC] Section 1234A(1)."¹ Here, the Court noted, "the parties to the agreement (AbbVie and Shire) did not own … their own shares … that would have been exchanged in the proposed combination [and thus] none of the … Agreement's terms could have conferred 'rights or obligations with respect to [AbbVie or Shire shares]' because the power to confer such rights rested with the companies' public shareholders."

The Court emphasized that the Break Fee was triggered by AbbVie's board's decision not to recommend the merger, not by a failure to complete a transaction involving property. Therefore, the Court found that AbbVie did not have any rights or obligations "with respect to property" as defined by the statute. AbbVie and Shire did not own their own shares, which were the subject of the Proposed Transaction. At most, AbbVie could convince its shareholders to buy and sell stock.

The Court also noted that the legislative history of IRC Section 1234A supported its interpretation because Congress enacted IRC Section 1234A to make certain that gains and losses from transactions economically equivalent to the sale or exchange of a capital asset obtain similar treatment. Congress was concerned that, under prior law, taxpayers could elect the most advantageous tax treatment available to them by selling contracts that increased in value, realizing capital gain, and terminating any contracts that decreased in value, realizing an ordinary loss. Those concerns were not present because AbbVie's decision not to recommend the transaction was a service and not a transaction involving property.

The Court granted AbbVie's motion for summary judgment, allowing the deduction of the termination fee as an ordinary business loss, while denying the IRS's motion for summary judgment.

Implications

The Court's analysis of IRC Section 1234A's applicability to "break fees" is clearly a welcome development for payors of those fees. However, recipients of those fees, which may have been relying on IRC Section 1234A to treat the fee income as a capital gain, will likely have the opposite reaction.

In addition, the Court's narrow interpretation of IRC Section 1234A as only applying to "a right or obligation to exchange (i.e., to buy, sell, or otherwise transfer or receive) an interest in property" could impact items that tax practitioners have generally viewed as squarely within the reach of IRC Section 1234A. For example, a derivative on any property that requires cash settlement is not an obligation to exchange an interest in property at least as literally defined by the Court. Whether the Court's analysis was intended to narrow the scope of IRC Section 1234A to that extent is unclear.

Further, the Court's holding has implications for transaction costs generally governed by Treas. Reg. Section 1.263(a)-5. In the Court's view, AbbVie's obligation to recommend the transaction to its board was in the nature of a service and, thus, not within the purview of IRC Section 1234A. Therefore, it would follow that IRC Section 1234A should not apply to transaction costs because they are paid-for services, contrary to the IRS position in published guidance.² Further, the Court did not view the Proposed Transaction, which involved an acquisition of AbbVie stock, as involving a right or obligation with respect to property that was a capital asset in the hands of AbbVie. In other words, AbbVie's own stock was not a property interest owned by AbbVie. This latter position supports the view that IRC Section 1234A does not apply to a termination fee paid by a target in connection with an acquisition of the target's own stock.