Case by case: Tax deductions in merger and acquisition transactions
TAX ALERT |
An abbreviated version of this article was published in CVCA Central in September 2018.
As merger and acquisition (M&A) transactions continue to grow in scale and complexity, so have the associated transaction costs. Consequently, it makes the tax treatment of these outlays of greater importance to all parties. Notwithstanding the commonplace nature of transaction costs, their tax classification has remained a matter of contestation. The Canada Revenue Agency (CRA) has long challenged taxpayers on the deductibility of fees incurred as part of a transaction, making these a common target for audits.
Generally, a business expense is deductible if laid out to earn business or property income. A further evaluation is then required to determine if any general or specific limitations may apply to deny the deduction (for example, outlays of a capital nature). Historically, the courts have largely supported deductibility of transaction costs where such fees are incurred for the purposes of improving the target’s business by combining its business with those of the acquirer, or defending the ability of the business to continue to operate, such as in the context of a hostile takeover. This includes necessary advisory expenses that are ancillary to the business.
Transaction costs incurred by a business will always have deductible and non-deductible components, but determining how to segregate these costs has often been a matter of judgment with an added element of uncertainty given CRA’s audit history in this area. Recent case law has provided useful guidance for taxpayers on transaction costs in the context of an M&A transaction.
Rio Tinto Alcan Inc. v. The Queen  renewed the discussion over the deductibility of transaction costs by providing a framework under which such costs should be examined, and confirmed previous court decisions. The Tax Court of Canada (TCC), upheld by the Federal Court of Appeal, established the following broad categories into which costs may be initially classified:
a. Oversight costs: fees incurred for services that ‘assist the board of directors in deciding whether or not the M&A transaction should be approved as part of the board’s oversight function’. Such costs are incurred to investigate whether a capital asset should be created or not. However, they ‘still result from the current operations of the business as part of everyday concern of its officers in concluding the operations of the company in a business-like way’1.
Although oversight costs may at first seem to be capital in nature (as they relate to a capital transaction), the TCC stated that overseeing a business includes the proper management, allocation or reallocation of its capital for the purpose of maximizing the income-earning potential of the business. As a result, oversight expenses should be treated as current expenditures and should be deductible.
b. Execution costs: fees incurred for services that relate to the direct execution process of a capital transaction after having been approved by the board, and ‘that result or aid in the completion of the transaction’2. In other words, where fees are incurred that ultimately facilitate the acquisition or disposition of a capital asset (such as shares or assets of a business), the costs would be treated on account of capital and therefore be denied a current deduction. At this point, the taxpayer may be able to find some relief for a portion of the expense under other provisions of the Act.
With the above framework established, the TCC provided the following commentary in several cases on specific expenses:
I. Investment counsel fees/Board advisory
In Rio Tinto Alcan Inc. v. The Queen, the court treated advisor fees incurred for the purposes of creating financial models and analyzing strategies for developing the taxpayer’s business as oversight expenses that are deductible to the taxpayer. The purpose of such expenses was to obtain financial, valuation, market and pricing opinions with respect to a potential transaction and to determine, in fairness, if the board acted with due-care in approving the transaction. Investment counsel therefore assisted the board in the decision-making process and their oversight of the income-earning process of the corporation.
II. Contingent fees
In Rio Tinto’s case, a significant portion of the investment counsel’s compensation was derived from a ‘success-based fee’, payable upon the successful completion of the transaction. The Minister of National Revenue (“Minister”) argued that such a fee constitutes a ‘commission’, which is specifically excluded from permitted deductions. However, the TCC indicated that a receipt of a commission is not just determined by its contingency of a transaction occurring, but should also be calculated based on a percentage of the profit earned in connection with a transaction3. As the contingent fee in this case was a fixed fee, the court allowed the deduction of costs despite having been incurred after the board had made the decision to proceed with the transaction.
III. Public relations fees
Rio Tinto incurred expenses with respect to a communications strategy in support of the proposed transaction. This included development of a market for the shares of the capital stock that were to be issued as consideration as part of the proposed transaction. The court denied the deductibility of such costs because they were incurred to promote the implementation of the transaction as the board had already made the decision to proceed with the transaction.
IV. Reporting costs and management information circulars
The court denied the deduction of Rio Tinto’s fees for the preparation and filing of documents with the shareholders in connection with the transaction. This is in contrast to Boulangerie St. Augustin Inc. v. Canada4, where such costs were considered deductible as necessary business expenses, on the same basis as preparing annual reports. However, the TCC distinguished the Boulangerie case from the Rio Tinto case as in the former situation, the reports were being provided to Boulangerie’s own shareholders as opposed the target corporation’s shareholders in the latter. The reports were also not considered as a ‘financial report’ pursuant to the deduction permitted. The Boulangerie case established that a ‘financial report’ corresponds to an annual report that includes the corporation’s financial statements and often officers’ comments on the corporation’s activities. While such financial information was also provided in the Rio Tinto reports, it also seemed to include much more than financial information, the nature and purpose of which was harder to discern.
V. Break fees
A break fee is a payment typically made in the context of a transaction by one party to the other in order 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 Queen5, Morguard was in receipt of such a payment, which it argued was on account of capital. As the fee 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 Minister argued that such a receipt should be included in income as ordinary business income.
The TCC ruled in favour of the Minister – since Morguard was in the business of making strategic acquisitions in real estate companies, 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. This is in contrast to the framework established in Rio Tinto as one could argue that the payment was part of an execution cost where the taxpayer is not in the business of buying and selling businesses. This contrast is a reminder that the tax treatment turns heavily on the facts and circumstances of each particular situation and the business activities of the taxpayer.
Using the framework above, the TCC ruled in favor of Rio Tinto and granted a deduction of approximately $50 million determined to be oversight costs, which the CRA originally argued to be non-deductible capital outlays. Although Rio Tinto provides additional guidance on this issue, understanding the tax treatment of a specific transaction cost can still be a difficult exercise, requiring a degree of interpretation, which considers other facts and circumstances. Whether or not the CRA will adjust their assessment practice based on the Rio Tinto ruling is still unclear but transaction costs and associated fees will continue to attract the attention of CRA auditors. Therefore, parties to an M&A transaction should keep in mind the importance of reviewing agreements, invoices and other documentation to determine the tax classification of transaction costs and ensuring advisors can provide sufficient details to support the associated treatment.
1 Canada v. Rio Tinto Alcan Inc., 2018 CarswellNat 3244, 2018 FCA 124
4 Boulangerie St-Augustin Inc. v. Canada,  2 C.T.C. 2149, 95 D.T.C. 56, 95 D.T.C. 164, 95 D.T.C. 164
5 Morguard Corporation v. R., 2012 TCC 55,  3 C.T.C. 2171, 2012 D.T.C. 1099