“Break fees” taxable as income

If a company receives a “break fee” in a failed takeover attempt, that fee is income for tax purposes, not a capital gain or a non-taxable “windfall.”

The distinction was made clear when the Federal Court of Appeal (FCA) recently released its decision in Morguard Corporation v The Queen (2012).

Morguard and its predecessor company were in the business of buying real estate companies. In the summer of 2000, it moved to acquire publicly traded Acanthus Real Estate Corp. in a friendly takeover. A third party, however, entered the fray and outbid Morguard. It won the prize and Acanthus paid Morguard a $7.7-million break fee.

Break fees are essentially fees paid by a target company to bidders if the pending deal is not realized. The underlying purpose of these fees is to compensate the bidder for the time and costs associated with putting together a takeover bid.

The problem arose when Morguard treated the $7.7-million break fee as a capital gain when it filed its corporate income taxes. The Canada Revenue Agency (CRA) reassessed Morguard on the basis that the fee was income, not capital. Morguard appealed this reassessment and the matter made its way to the Tax Court of Canada (TCC). In February, the TCC released is decision, agreeing with the CRA; Morguard then appealed to the FCA.

The TCC’s decision  noted: “The break fee is an integral part of, and in the ordinary course of, its regular commercial business operations and activities. Through the relevant period, this taxpayer’s continuing and recurring business included acquiring significant controlling positions in public real estate companies.”

In making its decision, the TCC relied heavily on the Supreme Court of Canada’s (SCC) judgment in Ikea v Canada (1998), a case that clarified how to characterize extraordinary or unusual receipts in the business context. In Ikea, the SCC considered whether a tenant-inducement payment received in respect of a long-term lease of store premises was on income or capital account. It was decided that the payment was an income receipt because it was received as part of the ordinary business operations of Ikea and was inextricably linked to such operations, even though it was received as a result of negotiations for a long-term lease, which would be a capital property.

Morguard’s primary position in its appeal to the FCA was that it received the break fee as a non-taxable capital receipt and that the TCC’s interpretation and application of Ikea was incorrect. It also contended that the TCC trial judge made a mistake when applying the legal test from the FCA decision, The Queen v Cranswick (1982), which addresses the applicable characterization of receipts as windfall gains, which are not subject to tax.

Seven different factors were taken into consideration in Cranswick in order to make the characterization. Although all are relevant, the presence or absence of a few of them is not wholly conclusive. The factors to consider from Cranswick are:

1. Was there an enforceable claim to the payment?
2. Was there an organized effort to receive the payment?
3. Was the receipt sought after or solicited in any manner?
4. Was the payment expected to be received?
5. Was there any foreseeable element of recurrence?
6. Was this a customary source of income to the taxpayer?
7. Was this in consideration of, or in recognition of, property, services or anything else provided or to be provided by the taxpayer either as a result of any activity or pursuit of gain carried on by the taxpayer or otherwise?

In the Cranswick decision, Justice Ledain described how to apply these factors to specific circumstances: “In the absence of a special statutory definition extending the concept of income from a particular source, income from a source will be that which is typically earned by it or which typically flows from it as the expected return.”

The FCA found no error in the TCC judge’s application of the principles in this case and noted that Ikea was not based on a particular factual finding, but “involved consideration of a number of factors, including the commercial purpose of the payment and its relationship to the business operations of the recipient.”

The decision essentially boiled down to whether the taxpayer could expect this payment in the regular course of business. After a full consideration of the factors, the FCA confirmed the TCC’s finding that the break fee paid to Morguard was income and not capital.

Greer Jacks is updating jurisprudence in  EverGreen Explanatory, an online research library of assistance to tax and financial professionals in working with their clients.