Case By Case: Tax Deductions In Merger And Acquisition Transactions
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. 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. 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.
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:
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’[i], including the proper management, allocation or reallocation of its capital for the purpose of maximizing the income-earning potential of the business. Oversight expenses in this context would be treated as deductible current expenditures.
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’[ii]. 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.
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. 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 transaction[iii]. 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. Canada[iv], 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.
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. In Morguard Corporation v. The Queen[v], Morguard was in receipt of such a payment, which it argued was on account of capital. 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. 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.
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. Understanding the tax treatment of a specific transaction cost can 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. Parties to an M&A transaction should keep in mind the importance of reviewing agreements, invoices and other documentation to support the tax treatment of various transaction costs
[i] Canada v. Rio Tinto Alcan Inc., 2018 CarswellNat 3244, 2018 FCA 124
[iv] 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
[v] Morguard Corporation v. R., 2012 TCC 55,  3 C.T.C. 2171, 2012 D.T.C. 1099
About the authors: Bhavin Oza is a senior manager and Stephen Rupnarain is a partner delivering M&A tax advisory at RSM Canada.