In a significant win for taxpayers, the U.S. Tax Court recently ruled in AbbVie Inc. v. Commissioner, Docket No. 2597-23, that a $1.6 billion "Break Fee" paid by AbbVie qualifies as an ordinary and necessary business expense under Section 162 of the Internal Revenue Code. The decision rejects the IRS' position that the payment should be treated as a capital loss under Section 1234A, marking a pivotal interpretation of how termination fees related to failed mergers or acquisitions are taxed. This ruling could have far-reaching implications for corporate tax planning and the treatment of similar break-up fees in future transactions.
Section 1234A
Section 1234A addresses the tax treatment of gains or losses from certain contract terminations and provides that any gain or loss is treated as capital gain or loss if it results from the cancellation, lapse, expiration or other termination of:
- a right or obligation with respect to property that is (or on acquisition would be) a capital asset in the hands of the taxpayer
- a Section 1256 contract, which is a capital asset in the hands of the taxpayer
The intention behind Section 1234A is to ensure that transactions economically equivalent to the sale or exchange of a capital asset receive similar tax treatment, particularly preventing strategies where taxpayers artificially create ordinary losses by canceling contracts that would otherwise yield capital losses if executed.
AbbVie Inc. v. Commissioner
By way of background, AbbVie is a domestic biopharmaceutical company known for researching, developing, manufacturing and selling pharmaceutical products. In 2014, AbbVie and Shire plc, a foreign public limited company, agreed on a proposed combination, underpinned by multiple agreements, including a Cooperation Agreement. Pursuant to the terms of the Cooperation Agreement, AbbVie agreed to pay a significant termination fee (Break Fee) to Shire if certain events occurred such as the failure of AbbVie's board to recommend the merger to its shareholders.
On Sept. 22, 2014, the U.S. Department of the Treasury issued IRS Notice 2014-52 announcing forthcoming new regulations concerning inversion transactions, which would likely have adversely affected the anticipated benefits of the AbbVie-Shire combination. In response to the Treasury Department's notice, AbbVie's board withdrew its recommendation for the proposed combination, citing increased transaction uncertainty attributable to the anticipated new regulations.
On Oct. 20, 2014, AbbVie and Shire formally entered into a Termination Agreement to end the Cooperation Agreement. In accordance with the Termination Agreement, AbbVie paid Shire a Break Fee of approximately $1.635 billion.
AbbVie deducted the Break Fee on its 2014 tax return under Section 162, which allows taxpayers to deduct all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Alternatively, AbbVie claimed that even if the Break Fee was not deductible under Section 162, it should qualify as a loss deductible under Section 165, which permits a deduction for any loss sustained during the taxable year that is not compensated by insurance or otherwise.
The IRS disallowed this treatment, arguing that AbbVie should treat the Break Fee paid to Shire as a capital loss under Section 1234A, rather than as an ordinary business expense deduction. The IRS reasoned that the payment related to the termination of an agreement that established rights and obligations "with respect to property" that should be classified as a capital asset.
AbbVie contested the IRS' determination, maintaining that the Break Fee was correctly treated as an ordinary business expense deduction. AbbVie asserted that the Cooperation Agreement, under which the Break Fee was established, was an agreement related to services to facilitate approval of the transaction rather than one involving rights or obligations with respect to property or capital assets. The parties filed cross motions for summary judgment as the facts were not in dispute. Ultimately, the U.S. Tax Court found in favor of AbbVie, allowing the deduction of the Break Fee as an ordinary business expense rather than as a capital loss under Section 1234A.
The Decision
The Tax Court's decision was based on several key findings. First, the Cooperation Agreement between AbbVie and Shire primarily focused on mutual commitments related to obtaining regulatory approval and the provision of corporate facilitative services rather than any direct transaction involving property rights (i.e., it provided that the parties would seek approval for the transaction, it did not obligate any party to complete the transaction). Furthermore, the Break Fee was triggered by the AbbVie board's decision not to recommend the merger to its shareholders, highlighting that the core obligations under the Cooperation Agreement centered on facilitating the proposed merger rather than consummating it.
In interpreting the phrase "with respect to property" in Section 1234A, the court determined that it refers to rights or obligations involving a direct or potential exchange of property interests. The court noted that the parties to the Cooperation Agreement did not own the property to be exchanged (i.e., the stock of each company, which was instead owned by their respective shareholders). Accordingly, the parties to the Cooperation Agreement didn't own any of the property that ultimately would be exchanged if a combination was completed and therefore could not contractually bind one another to complete such a transaction.
Tips for Navigating Termination Fees Post-AbbVie
Perhaps the key takeaway in AbbVie is the importance of carefully considering whether the contract at issue obligates the parties to complete a transaction or merely facilitate one. When obligations are service-oriented – especially when the property to be transferred is owned by parties other than those to the agreement – termination fees may be treated as ordinary expenses, potentially leading to more favorable tax outcomes. Once the drafting has been carefully considered, other helpful insights include the following:
- Consider What Code Provisions Other Than Section 1234A Might Apply. Do not assume that a break or termination fee is necessarily a deductible expense under Code Section 162 simply because Code Section 1234A does not characterize the payment as capital in nature. For example, there are regulations under Code Section 263 that require break fees to be capitalized if the payer is terminating the transaction in order to enter into another transaction.
- Evaluate the Overall Implication of Break Fees or Termination Fees. Consider how break fees or termination fees in agreements are treated for financial reporting purposes.
- Documentation and Record Keeping. Maintain comprehensive records of all agreements and related documentation. This helps in substantiating the nature of payments for tax-related and audit-related purposes.
