IRS Changes Course on Characterization of Termination Fees
Termination fee clauses are commonly incorporated in merger agreements to compensate a party for time and expenses incurred in the event that the deal is not consummated. Where the merger is terminated by one party, the clause generally requires either the target to pay the acquirer a termination fee (if the target terminates), or the acquirer to pay the target a reverse termination fee (if the acquirer terminates). Typically, termination fees range from 1–3 percent of the transaction value, which may result in a cash payment in the billions of dollars depending on the size of the transaction. The tax treatment of termination fees, both in terms of deductibility or income inclusion and the character of the fee as either ordinary or capital, has been the subject of past litigation, Internal Revenue Service (IRS) regulatory action, and informal IRS advice.
Internal Revenue Code (Code) Section 165 allows a deduction for any loss sustained during the taxable year and not compensated for by insurance or otherwise. Section 162 provides deductions for ordinary and necessary business expenses paid or incurred during the taxable year. In contrast, Code Section 263 provides generally that a deduction is not allowed for new buildings or for permanent improvements or betterments made to increase the value of any property of estate. Prior to the promulgation of the INDOPCO regulations, litigation ensued over whether the payor of a termination fee could deduct such payment under Code Sections 162 or 165 or had to capitalize the payment under Code Section 263. In 2003, the IRS promulgated the INDOPCO regulations and specifically addressed the situations under which termination fees could be deducted immediately.
The above-referenced litigation and the INDOPCO regulations focused on the deductible versus capital issue and did not address the character a termination fee (either paid or received). However, informal IRS guidance treated termination fees as liquidated damages, and thus ordinary income, arguably because the taxpayer had not sold, exchanged or transferred any capital asset. See, e.g., Private Letter Ruling 200823012 (June 6, 2008), available here and Tech. Adv. Memo. 200438038 (Sept. 17, 2004), available here. In the Private Letter Ruling, the IRS held that Code Section 1234A, which provides that gain or loss attributable to the cancellation, lapse, expiration or other termination of a right or obligation with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer is treated as gain or loss from the sale of a capital asset, did not apply. However, in, recent guidance released in September and October of this year available here and here the IRS reversed course and provided that Code Section 1234A applies to termination fees pursuant to merger agreements. The IRS’s new position is that a target’s stock to which the termination fee relates would have been a capital asset in the hands of an acquirer, had the deal been completed, and that the acquisition agreement provides rights and imposed obligations on both parties as to the target’s stock, therefore making section 1234A applicable and requiring capital treatment.
The tax treatment of termination fees, both from a standpoint of current deductibility versus capitalization and the nature of the fees, is a significant issue for affected taxpayers. It remains to be seen whether taxpayers will challenge either the INDOPCO regulations, which overrule prior judicial precedent, or the recent IRS guidance applying Code Section 1234A. Taxpayers facing either of these situations need to carefully consider how best to report transactions involving termination fees and be prepared to argue their position during audit if the IRS believes such position is contrary to the agency’s current positions. Taxpayers may also want to consider whether to formally disclose their positions, such as on Form 8725 or Form 8275-R, to protect against any potential penalties that the IRS may assert.