Chief Counsel's Office Advises That Termination Fees Are Capital Losses Under Code Section 1234A

(Parker Tax Publishing June 2022)

The Office of Chief Counsel advised that a corporate taxpayer's payment of termination fees in connection with the termination of a merger agreement and an acquisition agreement gave rise to losses under Code Sec. 165 rather than business expenses under Code Sec. 162. Thus, the Chief Counsel's Office determined that Code Sec. 1234A applied to characterize the Code Sec. 165 losses that resulted from the terminations of the transactions as capital losses to the extent those losses were attributable to the termination of rights or obligations with respect to capital assets. CCA 202224010.

Facts

The Office of Chief Counsel was asked to advise whether the termination fees a taxpayer, a C corporation, paid in connection with the termination of (1) a merger agreement with a target, and (2) an acquisition agreement with a buyer should be treated as capital losses under Code Sec. 1234A or whether the taxpayer properly claimed the fees as business expense deductions under Code Sec. 162.

The merger agreement provided that the taxpayer or the target could terminate the agreement if the merger was not consummated by a specified date. If such a termination was triggered and certain other circumstances existed, the taxpayer was required to pay the target a termination fee (referred to as a "reverse termination fee" because the acquirer, rather than the target, was required to pay it). Due to the impracticability, if not impossibility, of proceeding with the merger, the taxpayer and the target agreed to terminate the agreement and the taxpayer paid the reverse termination fee. Litigation ensued, and in an effort to address issues raised in the lawsuit, the taxpayer entered into an acquisition agreement with a buyer. This agreement was also terminated, and the taxpayer and the buyer executed a termination agreement in which the taxpayer agreed to pay a termination fee to the buyer.

The taxpayer reported the reverse termination fee and the termination fee (collectively, the termination fees) as ordinary business expense deductions under Code Sec. 162 on its Form 1120, U.S. Corporation Income Tax Return. On audit, the IRS considered disallowing the ordinary business expense deductions and recharacterizing the fees as capital losses under Code Sec. 165 and Code Sec. 1234A. Code Sec. 1234A provides, in part, that the 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.

The taxpayer argued that its payment of the termination fees resulted in deductible Code Sec. 162 expenses and that Code Sec. 1234A applied to losses but not to Code Sec. 162 expenses. The taxpayer asserted that Reg. Sec. 1.263(a)-5(c)(8) provides that a fee paid to terminate a merger agreement can be deducted when paid unless the fee was paid to engage in a second, mutually exclusive capital transaction. The taxpayer inferred that, if the termination fees were not expressly capitalized under the regulations accompanying Code Sec. 263(a), then they must necessarily be deductible (as Code Sec. 162 expenses) when paid. The taxpayer contended that case law pertaining to merger termination fees and the origin-of-the-claim doctrine required that the IRS accept the taxpayer's treatment of the termination fees as Code Sec. 162 expenses. Lastly, the taxpayer argued that the termination fees were deductible as Code Sec. 162 expenses because they were negotiated to compensate the target and the buyer for their transaction costs.

Office of Chief Counsel's Analysis

The Office of Chief Counsel concluded that:

(1) the taxpayer's terminations of the transactions resulted in dispositions under Code Sec. 1001 that gave rise to losses under Code Sec. 165 rather than business expenses under Code Sec. 162;

(2) the regulations accompanying Code Sec. 263(a) did not require that the termination fees be treated as Code Sec. 162 expenses;

(3) the case law pertaining to merger terminations and the origin of the claim doctrine did not require that the IRS accept the taxpayer's treatment of the termination fees as Code Sec. 162 expenses; and

(4) Code Sec. 1234A applied to characterize the Code Sec. 165 losses that resulted from the terminations of the transactions as capital losses to the extent those losses were attributable to the termination of rights or obligations with respect to capital assets.

For a discussion of the treatment of gains or losses on termination of certain contracts, see Parker Tax ¶116,130. For a discussion of the requirements for the deduction of an abandonment loss, see Parker Tax ¶114,510.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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