TaxMatters@EY - February 2013
Break fees ruled to be fully taxable
Morguard Corporation v The Queen, 2012 FCA 306
Jennifer Smith, Ottawa
The proper treatment of transaction costs is an evolving area of Canadian tax law. Because there is nothing in the Income Tax Act that deems amounts paid to cancel a business contract, known as break fees, to be income or capital, this issue has been the subject of a number of court decisions, most of which turned on the relevant facts and circumstances.
A prospective purchaser often enters into a support agreement with the target corporation as part of a share acquisition (particularly a public takeover). Under this agreement, the target corporation usually agrees to facilitate and support an offer from the purchaser by providing access to information and recommending the offer to shareholders, and by not supporting any competing offers. In many cases, support agreements also contain a break fee, whereby the target agrees to compensate the purchaser if the target breaches any of its obligations under the support agreement (e.g., if it supports a competing offer).
In Morguard, the Federal Court of Appeal (FCA) agreed with the Tax Court of Canada (TCC) that a $7.7-million break fee paid to the taxpayer was on income account because it was received as an integral part of, and in the ordinary course of, the taxpayer’s ordinary business operations.
The break fee in the Morguard case arose out of the taxpayer’s unsuccessful takeover bid for Acanthus Real Estate Corporation (Acanthus).
The taxpayer first made a takeover bid for all of the shares of Acanthus in June 2000, and the bid was supported by the Acanthus board of directors pursuant to a pre-acquisition agreement entered into on 23 June 2000.
The initial agreement contemplated a $4.7-million break fee to be paid to the taxpayer if the board supported a competing bid. This break fee was later increased to $7.7 million when the taxpayer’s takeover bid was increased in response to a competing bid. Eventually, the taxpayer lost out to the competing bidder and received the $7.7-million break fee from Acanthus.
In filing its income tax return for the 2000 taxation year, Morguard reported its taxable capital gain on the sale of its Acanthus shares. It also reported the $7.7-million break fee, net of bid expenses of approximately $1.8 million, as a capital gain.
In 2005, the Minister reassessed Morguard to remove the taxable capital gain related to the $7.7-million break fee, replacing it with an income inclusion. Morguard appealed unsuccessfully to the TCC, and then to the FCA.
Tax Court decision
Tax Court of Canada Justice Patrick Boyle reviewed the evidence and found at the outset that Morguard negotiated its rights to, and received, the break fee as an integral part of, and in the ordinary course of, its regular commercial business operations and activities.
“Throughout the relevant period, the taxpayer’s continuing and recurring business included acquiring significant controlling positions in public real estate companies. Its acquisitions of its Acanthus shares and its takeover bid for Acanthus fit this same pattern even though the takeover was unsuccessful and resulted in the consolation prize of a $7.7-million break fee....” (para 30).
This finding set the stage for the conclusion that the break fee was on income account. However, Justice Boyle also provided a brief analysis of the relevant principles, as summarized below.
Justice Boyle rejected the taxpayer’s argument that the break fee was not taxable because it was a capital receipt that did not relate to a disposition of any property, as in the case of Fortino et al. v The Queen (2000 DTC 6060 (FCA)).
He indicated the proper approach to determining whether an amount was a non-taxable capital receipt was that set out in The Queen v Cranswick ( 1 F.C. 813), which sets out seven factors for determining the existence of a “windfall.” The break fee failed most of these tests.
Having decided that the break fee was not a non-taxable capital receipt, Justice Boyle went on to consider whether it was on income or capital account. He relied on the decision of the Supreme Court of Canada in the case of Ikea Ltd. v Canada (98 DTC 6092) in reaching his conclusion that the break fee was income to Morguard.
He cautioned against relying on the formulaic approach set out in the earlier cases of Neonex International Ltd. v The Queen (89 DTC 6339 (F.C.A.)) and Firestone v The Queen (87 DTC 5237 (F.C.A.)), both of which considered amounts associated with unsuccessful acquisitions to be on capital account because they related to capital acquisitions.
In Ikea, a tenant inducement payment was considered to be on income account. The Supreme Court agreed with the lower courts that the receipt of this amount was a necessary incident of the conduct of Ikea’s business and was inextricably linked to such business, even though it was received as a result of negotiations for a long-term lease which would be a capital property.
Justice Boyle applied a similar approach and dismissed Morguard’s appeal.
Federal Court of Appeal decision
The FCA dismissed Morguard’s further appeal on 21 November 2012. Justice John Maxwell Evans delivered the brief reasons on behalf of the panel of three judges.
Morguard conceded at the FCA that the break fee was not received as the proceeds of disposition of capital property. Therefore, it was either income or a non-taxable capital receipt. (Note that the break fee was received in 2000, prior to the 2006 amendments to the definition of “cumulative eligible capital” in subsection 14(5)) of the Income Tax Act.
Morguard did not attempt to challenge Justice Boyle’s factual determination that the break fee was paid pursuant to an agreement negotiated in the ordinary course of its normal business activities, and that the receipt of the break fee was a normal and expected incident of those activities.
Instead, Morguard argued that the acquisition of capital properties was not and could not, as a rule of law, be a business in itself, based on the decisions in Neonex and Firestone. Further, Morguard argued that Justice Boyle had misapplied the principles in Ikea, because the result in that case was based on a factual conclusion that the payment in issue was a reimbursement of rent (an expense on income account).
Justice Evans did not accept that the Neonex or Firestone cases established the rule of law suggested by the taxpayer, or that principles set out in the Ikea decision should be given such a limited application. In his view, the test applied in Ikea involved the consideration of a number of factors, including the commercial purpose of the payment and its relationship to the recipient’s business operations. The tenant inducement payment in that case was received as part of Ikea’s ordinary business operations and was inextricably linked to such operations, even though it was received as a result of negotiations for a long-term lease which was a capital property.
FCA Justice Evans held that given the facts, and applying the linkage test set out in Ikea, it was open to TCC Justice Boyle to conclude that Morguard received the break fee on income account because it was received as an integral part of, and in the ordinary course of, the taxpayer’s ordinary business operations.
Morguard has not filed leave to appeal to the Supreme Court of Canada.