It's not unusual for companies involved in an impending merger to agree that a substantial termination fee must be paid to one party if the deal doesn't go forward because the other party calls it off. When this happens, it's often because the party canceling the deal is presented with a more enticing alternative.
So what is the proper federal income tax treatment of a termination fee paid to extricate a target company from a merger agreement so that the target can pursue a more attractive buyout deal? The IRS provided the answer for one set of circumstances in a Technical Advice Memo.
In this case, Company A agreed to acquire all of the stock of Company B in what would ultimately be a merger between the two communications outfits. However, the merger agreement allowed Company B to opt to pay a termination fee in order to pursue a superior proposal if one developed. Indeed, one of Company B's largest shareholders had reservations about the impending merger. He received permission to try to drum up a better deal. Sure enough, he put together a new proposed transaction with Company C, which was perceived by Company B's board to be superior. The board therefore voted to terminate the original deal and to authorize a new merger.
Company A was informed by Company B that it had found a more attractive merger partner. Company B agreed to pay the stipulated termination fee and also gave Company A the opportunity to make a counter proposal in response to Company C's more lucrative offer. However, Company A declined to counter and agreed to accept the termination fee. Company B's shareholders then approved the merger with Company C, and the deal went through as contemplated.
On its federal income tax return, Company B claimed a current deduction for the termination fee paid to Company A. The nature of the payment was disclosed on an IRS Form 8275, Disclosure Form, filed with the tax return. The purpose of this form is to notify the IRS that the taxpayer is taking an aggressive position that the IRS might disagree with. The deduction was described as compensation paid to Company A for breach of the merger contract. By making the disclosure on Form 8275, Company B was shielded from IRS penalty assessments if the deduction was disallowed.
Not surprisingly, it was. The IRS concluded the termination fee was a nondeductible capital expenditure that was directly related to the merger between Company B and Company C. Citing a Supreme Court decision (described in the right-hand box), the government said the termination fee had to be capitalized under Section 263 of the Internal Revenue Code, rather than currently deducted.
More specifically, capitalization was required because the termination fee was part and parcel of a transaction that was anticipated to produce long-term and substantial economic benefits for Company B (the merger with Company C was expected to take advantage of synergies between the two companies). The IRS elaborated that expenditures to change a corporation's capital structure for the benefit of future operations generally must be capitalized, under Section 263, because they are typically expected to create economic benefits over a long period of time. (IRS TAM 200512021)
Bottom Line: Although a merger termination fee might appear on first blush to be just an annoying expenditure, it may actually be a necessary cost of implementing a more beneficial transaction. If so, the IRS will require capitalization, under Section 263. On the other hand, if the termination fee is paid to extricate a company from a bad deal with no replacement transaction forthcoming, a current deduction should be allowed — because the fee is truly cash out the door with no offsetting benefit.
The Supreme Court INDOPCO case,which was cited in the IRS Technical Advice Memo, provides instrumental guidance for corporations involved in mergers and acquisitions. The high court held that $2.75 million in investment banking fees that were incurred by a target corporation in connection with its friendly acquisition must be capitalized.
Reason: The fees could be expected to produce a "significant future benefit" once the acquisition was consummated. (INDOPCO Inc. v. Commissioner of Internal Revenue, 503 U.S. 79, 1992)
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