In an M&A transaction, buyers often incorporate language into purchase agreements that institute a termination fee the target company pays when such agreements aren’t consummated.
Two recent rulings addressed the appropriate tax treatment of such termination fees.
In October 2016, the IRS issued Chief Counsel Advice 201642035, which included two examples of a company receiving a merger termination fee from a target company.
Example A involved the target company paying a potential acquirer a $1 million termination fee when the target terminated the transaction and pursued a superior offer from another acquirer.
As the target’s stock is considered a capital asset under Internal Revenue Code Section 1221, and the termination fee received is related to the termination of the acquirer’s right with respect to the target’s stock, the fee is considered a gain from the sale of a capital asset that is recognized by the acquirer within §1222 and §1234A.
The gain is then reduced by the amount of facilitative costs paid for investigating and pursuing the transaction.
Example B mirrored Example A except the facilitative costs paid by the acquirer exceeded the amount of the termination fee received from the target. In this case, a capital loss was generated.
In September 2016, the IRS released Legal Advice Issued by Field Attorneys 20163701F.
The publication’s purpose was to determine whether a merger termination fee leads to a capital loss within §1234A for an acquirer that entered into an agreement to acquire a target corporation.
In this example agreement, the taxpayer would be required to pay a termination fee to the target corporation if the taxpayer withdrew from the merger.
The termination fee resulted in a capital loss for the taxpayer under §1234A. This was due to the merger agreement giving the taxpayer the right to acquire stock in the target corporation.
In the event of a capital loss, the deductibility of that loss may be limited depending on multiple factors.
The author advises companies to be aware of deduction limitations when analyzing the tax effect of termination fees.
A company’s ability to plan for fees and manage any available capital gains can enhance the possibility that capital losses can be used in some form.