Are Break-up Fees Lost Profits?

A recent IRS ruling gets to the heart of the matter -- and the "origin of the claim."

Breaking up is hard to do, especially when termination fees are imposed on the deal. Earlier this year, the Internal Revenue Service addressed the often-encountered, but surprisingly elusive, question of how “break-up” or termination fees are properly taxed (See Letter 2008823012, issued on March 10, 2008.) To be sure, termination fees indisputably constitute gross income. The fees are clearly “accessions to wealth” over which the recipient has dominion and control. In addition, break-up fees do not fall within any of the statutory exclusions to the definition of gross income.

In the IRS ruling, an example was set up to underscore the tax treatment. The example involves a taxpayer, which we will call Omega Ltd., which enters into an agreement on June 1, to acquire Beta Inc. The proposed acquisition, however, is subject to a number of “substantial conditions,” including the requirement that shareholder approval be obtained.

On June 20, an interloper — Chi Corporation — appears on the scene and makes an unsolicited tender offer to purchase all of the stock of Beta Inc. Beta’s board of directors likes the new deal. In fact, compared to the June 1 agreement, the directors believe that Chi’s offer may amount to a “superior proposal.” So Beta Inc. begins discussions and negotiations with Chi.

On June 30, Omega Ltd. and Beta Inc. terminate their merger deal, and based on the original agreement provisions, Beta pays Omega a termination fee. Then on July 5, Chi acquires control of Beta, and in doing so, triggers break-up provisions included in the original June 1 agreement, as well as the June 30 termination agreement. As a result, Beta pays Omega an additional termination fee.

Soon after, Beta asks the IRS to rule on whether the termination fees received should be treated as ordinary income as opposed to a capital gain. The IRS grants the ruling, focusing its decision on a venerable principle, the so-called origin of the claim.

Origin of the Claim

Under the origin of the claim doctrine, the taxability of a settlement or a judgment depends upon the “nature” of the claim, and the actual basis of recovery. (See United States v. Gilmore, 372 US 39 (1963).) While the Beta case does not involve a lawsuit, and therefore lacks a settlement or judgment, the IRS still concludes that contractual termination fees and settlements are sufficiently similar to lawsuit settlements or judgments. As a result, the agency applies the same principles as if the case included a lawsuit settlement.

Based on the doctrine, if the amount received in the Beta case represents “damages for lost profits,” it is taxable as ordinary income. On the other hand, if the recovery is received as the “replacement of capital” destroyed or injured, the money received is a return of capital, which is taxable only if it exceeds the basis of the destroyed capital. (See Freeman v. Commissioner, 33 T.C. 323 (1959).)

Discuss

Your email address will not be published. Required fields are marked *