Canadian Tax Adviser
December 6, 2011

CRA Rules on Tax Treatment of Break Fee Receipts

Evy Moskowitz
Toronto, Moskowitz + Meredith LLP

In a recent internal technical interpretation (TI), CRA Rulings was asked whether break fees received by a taxpayer should be included in income, or whether the amounts represented non-taxable capital receipts. CRA Rulings concluded that break fees received by a taxpayer on a failed transaction should be included in income under section 9 or paragraph 12(1)(x) of the Act or, alternatively, as proceeds of disposition of capital property under section 14.

This 14-page TI is interesting because it reviews several provisions in the Act and relevant jurisprudence including BJ Services Company, RCI Environnement and Manrell. The TI also considers the meaning of various terms including "property" and "reimbursement".

Facts
The facts in this TI are unclear since much of the information has been sanitized and no substitute names were given to the parties.

We assume that the facts are that a taxpayer (Purchaserco) received break fees from another taxpayer (Opco) as a result of Purchaserco's unsuccessful bid to acquire all of Opco's outstanding common shares.  

The TI notes that while break fees are common in most merger and acquisition transactions, it does not appear that taxpayers consistently characterize break fees receipts.

Issue
CRA Rulings was asked by the CRA auditors whether received break fees should be represented as:

• Income from business or property under subsection 9(1)
• Amounts to be given the same treatment as the item for which it was intended to compensate under the surrogatum principle
• Eligible capital amounts
• Income such as an inducement or reimbursement under paragraph 12(1)(x)
• Capital gains
• Non-taxable capital receipts.

Audit's position
In the CRA auditors' request to CRA Rulings for its interpretation, the  auditors noted that the purpose of the acquisition was to combine the two corporations' operations to achieve operating synergies and efficiencies, enhance future growth and be better positioned to compete for acquisition opportunities as the corporations' industry continued to consolidate. Once achieved, all of these goals would maximize shareholder value.

As a result, the auditors' position is that the Tax Court of Canada's decision in BJ Services Company should be applied so that the break fees should be considered ancillary business income under subsection 9(1) of the Act.

Alternatively, the CRA auditors noted that break fees typically provide compensation to an initial bidder for its ongoing time and effort, out-of-pocket expenses, internal costs and opportunity cost if an event occurs which prevents the bid from being completed. As such the CRA auditors said that the surrogatum principle should apply so that the tax treatment of a settlement payment or damages should parallel the tax treatment for the item for which the payment is intended to compensate. Further, the break fees are compensation for transaction costs (or wasted expenditures) incurred by Purchaserco, and opportunity costs due to the failed bid.

Where the break fees exceed the transaction costs incurred, the CRA auditors' opinion is that the excess value should be attributed to the forgone annual operating and corporate cost savings that is expected to be realized in the short term. Since any realized operating and cost savings are reflected in a company's profit under section 9 of the Act, then the surrogatum principle dictates that the portion of the break fees that was paid to compensate for the opportunity cost associated with foregone cost savings would also be on account of income and be included in income under subsection 9(1) in the year of receipt. Similarly, the tax treatment of the break fees intended to compensate for the transaction costs incurred by Purchaseco related to its takeover bid for Opco would parallel the tax treatment of the related costs.

Rulings' position
Before providing its opinion, CRA Rulings stated that "the characterization of a break fee receipt for income tax purposes may differ from case to case, depending on the particular facts of each case".

CRA Rulings agreed with the CRA auditors' rationale and conclusion that break fees should be included in income under subsection 9(1). CRA Rulings also agreed that break fees could represent a reimbursement, contribution or assistance for expenses incurred by Purchaserco in offering to purchase Opco's shares. As a result, where these fees were not included in income under subsection 9(1), they should be included in income under paragraph 12(1)(x).

CRA Rulings found that the break fees could also be considered proceeds of disposition of Purchaseco's rights under the bid for Opco's shares. As such, it found that the fees could be included in Purchaserco's income under subsection 14(1).

Interestingly, CRA Rulings stated that it was also necessary to consider whether the proposed restrictive covenant rules in section 56.4 could apply to the break fees. CRA Rulings stated that the restrictive covenant rules were broad enough to include the fees, unless they satisfied the exceptions to these rules in subsection 56.4(3).

For more information, contact your KPMG adviser.

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