TCC rules on taxation of break fees
In the recent decision Morguard Corp. v R., 2012 TCC 55, the Tax Court of Canada ("TCC") considered the proper tax treatment of a break fee in the hands of a recipient as a result of a failed takeover bid. Generally, a break fee is a fee that is paid by a potential target corporation in the context of a takeover bid to extinguish a relationship with a prospective acquirer where the acquirer's bid to purchase the target is not successful. The fee is paid to compensate the acquirer for its time and effort in making the bid. In Morguard, the TCC found that the break fee received by the taxpayer was taxable as income and not as a capital receipt.
The facts of Morguard are straightforward. The taxpayer was a Canadian public corporation in the business of acquiring controlling ownership positions in various real estate companies that owned and managed residential and commercial rental properties. For several years prior to the taxation year in question, the taxpayer made numerous real estate acquisitions, including significant positions in over a handful of real estate companies. By early 2000, it had assembled direct or indirect interests in 244 properties comprising over 38 million square feet and worth over $3 billion, which included a 19.2% common-share position in a company called Acanthus Real Estate Corporation ("Acanthus") upon its initial public offering.
The break fee in question arose out of the taxpayer's attempted acquisition of all the shares of Acanthus. In June 2000, the taxpayer made an unsolicited takeover bid to acquire the remaining shares of Acanthus for $8 per share. On June 23, the parties entered into a pre-acquisition agreement, whereby the taxpayer revised its bid to $8.25 per share and Acanthus agreed not to solicit other bids and to pay a $4.7 million break fee if its board of directors supported another bid. On June 30, Acanthus supported an unsolicited third party bid of $8.75 per share and paid the $4.7 million break fee to the taxpayer. On July 2, the taxpayer increased its bid to $9 per share and the parties entered into an amending agreement providing that a $7.7 million break fee would be paid by Acanthus. On signing the amending agreement, the taxpayer returned the original $4.7 million break fee. On July 18th, the rival bidder increased its bid as well, which Acanthus ultimately accepted. As a result, the taxpayer received the $7.7 million break fee and sold its interests to the rival bidder. This was the taxpayer's only unsuccessful public takeover bid and the first time it received a break fee and the first time it sold an ownership interest in any real estate company it had acquired.
Tax Court of Canada
The TCC held that the break fee did not constitute a non-taxable windfall because it did not meet a number of the factors established in the jurisprudence for determining whether an amount was received as a windfall. Moreover, the break fee was an income and not a capital receipt in the hands of the taxpayer given that: a) the taxpayer's regular business included acquiring significant controlling positions in public real estate companies; and b) it negotiated its rights to the break fee as an integral part of its ordinary course business.
In concluding that the amount was received on account of income, the TCC judge was careful to limit the decision to the particular facts of the case. The Court seemed particularly focused on the fact that, as mentioned before, the taxpayer was in the business of acquiring interests in public real estate companies, such that the potential and actual receipt of break fees could be thought of as expected incidents, however occasionally actually received, in its business. The Court also noted that the renegotiation of the break fee from $4.7 to $7.7 million as an amendment of the pre-acquisition agreement suggested that the potential of receiving the break fee had become an integral, if perhaps secondary, purpose of the pre-acquisition agreement. Notably, an expert witness had testified at trial that while the initial $4.7 million break fee was within the commercial range of break fees, the revised $7.7 million figure was at the high end of the range and may have exceeded the expected range.
Lastly, the TCC contrasted the taxpayer's case with a hypothetical situation of a white knight sought out by a reluctant target in respect to an unsolicited or hostile bid. The Court suggested that a break fee received in the latter situation may require a different analysis and have different tax consequences.
The taxpayer has appealed to the Federal Court of Appeal.
Unless the Federal Court of Appeal rules otherwise, the Morguard case tells us that companies that undertake a significant number of mergers and acquisitions transactions in the course of their ordinary business will likely need to include any break fees received in respect of an acquisition in calculating their income. However, the court seems to leave the door open for an argument that a break fee may be received on capital account where it is received by a taxpayer who is not generally an acquirer or bidder as part of its regular commercial business activities. Practically speaking, parties to an acquisition transaction should consider the after-tax amount when negotiating the break fee.
by Kathy Wang
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a cautionary note
The foregoing provides only an overview and does not constitute legal advice. Readers are cautioned against making any decisions based on this material alone. Rather, specific legal advice should be obtained.
© McMillan LLP 2012