5 March 2003 External T.I. 2002-0151425 - Deductibility of Break-Up Fee

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues: Whether break-up fee paid to terminate a merger agreement is: (1) deductible in computing business income, or (2) an eligible capital expenditure

Position: Question of fact, but generally no

Reasons: A break-up fee paid will normally be a capital expenditure and will not likely be made or incurred for the purpose of earning income

XXXXXXXXXX 2002-015142
Gwen Watson
March 5, 2003

Dear XXXXXXXXXX:

Re: Deductibility of Break-Up Fee

This is in reply to your letter of June 28, 2002, wherein you requested our views regarding the tax treatment, under the Income Tax Act (Canada) (the "Act"), of a "break-up fee" paid to terminate a merger agreement.

In your hypothetical scenario, Target and Purchaser are both taxable Canadian corporations and public corporations. Target and Purchaser have entered into a merger agreement and, subject to shareholder approval, Purchaser will issue shares of its capital stock to the shareholders of Target in exchange for their shares in the capital stock of Target. Under the merger agreement, either of Target or Purchaser may terminate the agreement upon payment of a substantial break-up fee to the other party.

You have asked for our views on whether the break-up fee paid by either Target or Purchaser will be currently deductible in computing business income, or alternatively, treated as an eligible capital expenditure and deductible under paragraph 20(1)(b).

Written confirmation of the tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an Advance Income Tax Ruling request. Where the particular transactions are completed, the inquiry should be addressed to the relevant Tax Services Office. However, we are prepared to provide the following comments.

Our Comments

Our position regarding the deductibility of payments made to cancel or terminate obligations or commitments is outlined in paragraph 15 of draft Interpretation Bulletin IT-467R2 Damages, Settlements and Similar Payments dated November 13, 2002. The Canada Customs and Revenue Agency (the "CCRA") is of the view that the tests used to determine the deductibility of damages will generally apply to determine the deductibility of contract termination fees. In this respect, paragraph 5 of draft Interpretation Bulletin IT-467R2 provides that damages will generally be deductible if they at least meet the following tests:

(a) the outlay must have been made for the purpose of gaining or producing income from the business or property (paragraph 18(1)(a));

(b) the outlay must not be on account of capital (paragraph 18(1)(b));

(c) the outlay must not be made for the purpose of earning exempt income (paragraph 18(1)(c));

(d) the outlay must not be a personal expense (paragraph 18(1)(h)); and

(e) the outlay must be reasonable in the circumstances (section 67).

In our view, the payment of the break-up fee by either of Target or Purchaser will generally be regarded as a capital expenditure and therefore not deductible in computing business income by virtue of paragraph 18(1)(b).

A break-up fee paid may constitute an eligible capital expenditure, as defined in subsection 14(5) of the Act, if the criteria outlined in paragraph 2 of Interpretation Bulletin IT-143R3 Meaning of Eligible Capital Expenditure dated August 29, 2002 are satisfied; namely, the payment must be:

(a) in respect of a business;

(b) as a result of a transaction occurring after 1971;

(c) on account of capital; and

(d) for the purpose of earning income from the business (whether or not income from the business was actually produced by such outlay or expense).

Although it is partly a question of fact, the CCRA is generally of the view that a break-up fee paid by Target or Purchaser will not be made or incurred for the purpose of earning income from a business, and accordingly, will not constitute an eligible capital expenditure.

We trust our comments will be of assistance to you. These comments are provided in accordance with the practice outlined in paragraph 22 of Information Circular 70-6R5, and are not binding on the CCRA.

Yours truly,

Mark Symes
Section Manager
for Division Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Policy and Legislation Branch