Acquisition agreements often provide for the payment of a termination or “break-up” fee where one party seeks to abandon the transaction without due cause under the agreement. For example, a target company may be required to pay the buyer a termination fee in the event the target wishes to terminate the transaction to pursue another, superior offer. A buyer, on the other hand, may be required to pay a “reverse termination fee” in the event the buyer is unable to obtain sufficient financing or requisite regulatory approvals to complete the transaction. Depending on the transaction and the type of fee, these fees can be in the range of 3-7% of the equity value of the target company. Given the potential magnitude of the amounts at stake, the manner in which such fees are treated for U.S federal income tax purposes can have a material impact on the actual value of the payment to the parties.

Two separate internal IRS documents suggest that, from a buyer’s perspective, the IRS would currently view a customary break-up fee payable upon a failed acquisition of target company as giving rise to capital gain or loss under current law. These documents contrast with earlier documents in which the IRS specifically permitted a buyer to recognize an ordinary loss on the payment of a break-up fee resulting from an abandoned transaction. The appropriate tax character of a break-up fee is a critical factor in analyzing the income tax impact associated with the receipt or payment of the fee, where parties’ desired tax treatment of a break-up may not necessarily be aligned.

What’s at Stake?

As a general matter, a recipient of a break-up fee will often prefer that the receipt of such fee be treated as giving rise to capital gain rather than ordinary income. For non-corporate taxpayers, capital gains attract a preferential rate of tax (currently 20%). While corporate taxpayers do not currently benefit from preferential rates of tax on capital gains, a corporate recipient of a break-up fee may nevertheless prefer capital gains treatment if such recipient has capital losses. In addition, a foreign recipient of a break-up fee from a U.S. payor generally would not be subject to withholding tax if that fee is treated as capital, but may be subject to withholding tax if the fee is treated as ordinary.

Conversely, a party required to pay a break-up fee in connection with a failed transaction generally will prefer such payment to result in an ordinary loss for tax purposes. This is because ordinary losses can be used to offset both ordinary income as well as capital gain.

Recent Memoranda

Last fall, the IRS released two internal memoranda regarding the tax treatment of break-up fees in the context of an M&A transaction. The first memorandum (FAA 20163701F), released in September 2016, involves a terminated inversion transaction in which a merger partner’s board of directors withdrew its shareholder recommendation for the transaction. As a result, the transaction was terminated and the merger partner was required to pay a break-up fee to the target company. The IRS concludes in the memorandum that the payment of the break-up fee resulted in a capital loss to the recipient pursuant to Section 1234A of the Code.

The second internal memorandum publicly released by the IRS in October 2016 (CCA 201642035) similarly concluded that the receipt of a break-up fee by a buyer in a merger transaction resulted in a capital gain to the buyer pursuant to Section 1234A rather than ordinary income. The break-up fee described in this second memorandum was triggered when a public company target received a superior purchase offer from a third party and terminated the merger agreement with the buyer to pursue a transaction with the third party.

Under Section 1234A, gain or loss that is attributable to the cancellation, lapse, expiration or other termination of a right or obligation with respect to property which is (or would be) a capital asset in the hands of the relevant taxpayer generally is treated as a capital gain or loss. In each of the memoranda, the IRS concluded that the applicable break-up fee was payable in connection with the termination of rights with respect to a target company’s stock, which would have been a capital asset in the hands of the applicable buyer. Therefore, from the buyer’s perspective, the IRS determined that the tax character of the break-up fee was capital in nature,

Prior IRS Analysis

The recent memoranda reach a contrary conclusion to that reached by the IRS in an earlier 2004 internal memorandum as well as a 2008 private letter ruling. In the earlier releases, the IRS concluded that the receipt by a buyer of a termination fee in a failed M&A transaction resulted in ordinary income for the buyer, in one release specifically ruling that Section 1234A did not apply to the transaction, which is inconsistent with current IRS thinking. This inconsistency is specifically acknowledged by the IRS in CCA 201642305.

Final Thoughts

The memoranda recently made public by the IRS provide some clarity for buyers in stock acquisitions that payment or receipt of a break-up fee can be treated as capital gains rather than ordinary income. However, there are still a number of questions facing buyers and sellers in this area. For instance, the memoranda do not address the taxation of the target or sellers. While one might think that sellers and buyers should be treated the same in these circumstances, this parity isn’t certain and there are some arguments for treating sellers differently. Moreover, the memoranda do not address the buyer’s treatment in certain transactions, such as when the acquired assets are not capital assets in their entirety. While we do not believe that the documents recently released by the IRS are likely to impact broader market practice with respect to break-up fees, these documents serve as a reminder that parties to an M&A transaction that includes a break-up fee should factor in the potential tax impact of any such fee when evaluating the transaction.