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IRS concludes that termination fee is capital under Section 1234A

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Tax Hot Topics: IRS concludes that termination fee is capital under Section 1234AThe IRS concluded in an internal legal memorandum (ILM 201642035), dated Feb. 9, 2016, but released on Oct. 14, that a fee related to the termination of an agreement resulted in capital gain or loss to the taxpayer under Section 1234A.

Under the facts of the memo, a corporate taxpayer entered into an agreement with another corporation (a target company), which provided that both parties agreed to undertake a series of steps toward the taxpayer’s acquisition of the target’s stock. At the time that the agreement was entered into, the target’s stock was publicly traded.

The agreement was a bilateral agreement that required both the taxpayer and the target to pursue a plan of merger and make their best efforts to effectuate the taxpayer’s proposed acquisition of the target’s stock, which included: (i) the taxpayer and target each recommending the deal to their respective shareholders, and (ii) the taxpayer and target obtaining the required governmental approvals.

The agreement provided that the target could terminate the agreement upon certain circumstances, but the target was required to pay a termination fee of $1 million upon such termination. The circumstances giving rise to a termination were (i) the target entering into another agreement based on a superior offer; (ii) a rejection of the taxpayer’s offer by the target’s shareholders; or (iii) a failure to obtain approval of the target’s shareholders by a certain date.

In this case, the target received a superior offer from another unrelated party, and entered into an agreement with that company.

The IRS contemplated two situations in the memo.  In the first situation, the taxpayer incurred $200,000 of facilitative costs related to its proposed acquisition of the target stock that were required to be capitalized under Treas. Reg. Sec. 1.263(a)-5. In the second situation, the taxpayer incurred $1.1 million of such costs required to be capitalized under Treas. Reg. Sec. 1.263(a)-5. The IRS concluded that the termination fee gave rise to capital gain or loss to taxpayer pursuant to Section 1234A in both situations.

Under Section 1234A, taxpayers are required to recognize capital gain or loss related to the cancellation, lapse, expiration, or other termination of a right or obligation (other than a securities futures contract as defined in Section 1234B) with respect to property that is (or would be) a capital asset in the hands of the taxpayer.

The IRS asserted in both situations that the target’s stock would have been a capital asset in the taxpayer’s hands. Therefore, Section 1234A applied because the agreement provided the taxpayer’s rights with respect to the target’s stock.

In the first situation, the IRS concluded that the taxpayer’s amount realized from the receipt of the termination fee of $1 million was reduced by taxpayer’s facilitative costs of $200,000. Accordingly, taxpayer had a capital gain of $800,000.

In the second situation, the IRS concluded that the taxpayer’s amount realized from the receipt of the termination fee of $1 million was reduced by the taxpayer’s facilitative costs of $1.1 million, resulting in a loss of $100,000. Accordingly, the taxpayer had a capital loss of $100,000.

Contact
Jeff Borghino
Partner, Washington National Tax Office
+1 202 521 1532

Bryan Keith
Managing Director, Washington National Tax Office
+1 202 861 4116


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