As businesses weather an unprecedented global economic turmoil due to COVID-19, it is clear that much of the mergers and acquisitions (M&A) environment has seen significant disruption as many deals in the process have terminated or paused with investors and owners alike grappling with what profitability may look like in a post-COVID-19 world. As the global economy has come to a standstill, business owners are forced to examine the impact of the crisis on their current business projections and strategy. Similarly, investors must also reconsider their investment options and where they can put their capital to its best use.
While many ongoing deals were accelerated to close, several have hit pause indefinitely and most have been terminated outright. In a period where liquidity has become a top priority, both sellers and buyers look toward ways of improving cash flow and preserving capital in preparation for when the economy begins to return to normalcy. As such, parties may be tempted to deduct transaction costs associated with delayed or terminated deals to reduce or recover taxes; however, the determination of the deductibility of such costs is not often a straight-forward task.
This article presents a follow-up to our previous analysis on the treatment of various transaction costs as per the decision in Rio Tinto Alcan Inc. v. The Queen (2018), where the courts provided a new framework for the deductibility of deal costs. We have curated additional costs that would be relevant to many of the existing deals that may have been affected by the current crisis.
1. Aborted or abandoned deals
The Canada Revenue Agency (CRA) has a long-standing view that transaction costs that were incurred by the purchaser in the course of a successful takeover, whether by way of the purchase of shares or assets, will largely be capital expenditures. In the case of an unsuccessful takeover, these costs will generally be accorded the same treatment, as either income or capital, had the takeover been successful.
Rio Tinto has generally been regarded as a win for taxpayers who are looking to deduct certain transaction costs that were investigative in nature, i.e., oversight costs that were incurred to assist the purchaser in deciding whether or not a deal should be pursued. Fees that are incurred for services that relate to the direct execution process of a capital transaction, i.e., execution costs, are generally capital expenditures. For aborted transactions, the framework established by Rio Tinto is instructive to assist in determining the appropriate classification of deal-related costs for tax purposes.
For expenses that are execution-type costs, taxpayers may be able to find some relief for a portion of the expense under other provisions of the Income Tax Act (the Act). Certain transactions costs may give rise to a Class 14.1 asset, which provides a tax deduction on a declining-basis basis at a rate of 5 per cent if such expense was incurred for the purpose of gaining or producing income from a business. In cases of aborted transactions, the CRA will accept such expenses under this category if the taxpayer can demonstrate that the taxpayer intended to make the business of the target corporation part of a similar business that the taxpayer already operated. The determination of similar businesses would depend on the facts and circumstances surrounding the purchaser and the intentions at the time of the deal.
2. Appraisal and valuation costs
The tax treatment of appraisal and valuation costs varies depending on the current phase or stage of the deal during which the costs are incurred. Where such costs were incurred on the onset of a deal and fit the criteria for oversight costs, such costs may be deducted for tax purposes as established by Rio Tinto. Given that the current crisis can have a significant impact on the future profitability of a target business, many purchasers are adjusting or re-trading deals in an attempt to capture the uncertainty created by the COVID-19 crisis on the purchase price and consideration structures. The treatment of such costs could vary depending on the facts surrounding the transaction and may have a unique outcome depending on the circumstances.
3. Debt and equity refinancing
Deflated valuations and low-interest rates have provided an attractive opportunity for businesses to consider refinancing their existing loan arrangements and entertain other non-cash expense alternatives to raising capital. Financing expenses in connection with issuing bonds or debentures, borrowing money for certain business or property purposes, or rescheduling or restructuring a debt obligation fall within paragraph 20(1)(e) of the Act that governs the treatment of such expenses. Generally, such expenses can be deducted over a period of five years for tax purposes.
An additional tax opportunity may arise when refinancing an existing third-party debt of the corporation. A complete write-off or deduction of previous 20(1)(e) expense balances may be available in the year of refinancing, provided the new debt has a substantially different set of terms associated with it. An analysis of the various terms and conditions would be required to conclude on whether previous 20(1)(e) balances could be written off.
Penalties are often levied upon the borrower on early retirement of debt or to renegotiate a lower interest rate on debt obligations. Such penalties are typically non-deductible expenses. However, where the purpose and use of the borrowed funds satisfy certain conditions, there may be all or a portion of the amount that can be currently deducted.
4. Break fees
A break fee is a payment typically made in the context of a transaction by one party to the other to withdraw from the transaction and allow it to pursue other opportunities more advantageous to its shareholders. The break fee serves to assist the other party in covering some of the professional fees incurred up to that point in the deal. In Morguard Corporation v. The Queen (2012), Morguard received break fees, which it argued were on account of capital. As the fees did not relate to a disposition of any property that could give rise to a capital gain, Morguard argued such an amount should therefore be a non-taxable capital receipt, i.e., as windfall or some extraordinary or unexpected receipt.
The courts did not rule in favour of the taxpayer. Morguard was in the business of making strategic acquisitions in real estate companies, and negotiating break fees with potential targets had become an integral aspect of the income-earning process of the corporation. Break fees, which are an ordinary incident in takeover bid negotiations, should, therefore, be treated on account of income. However, such expense may not similarly be deductible to the payor and would require further analysis.
Given the tax treatment of transaction costs could have a significant impact on a business’s financial health, as well as CRA’s audit history in this area, it is imperative to analyze such costs and segregate between deductible and non-deductible components.
Visit RSM Canada’s Coronavirus Resource Centre for additional business insights to bolster your firm’s response to the crisis.