The Tax Court of Canada (the “TCC”) considered the tax treatment of break fees in Morguard Corporation v. The Queen (2012 TCC 550) (“Morguard”) for purposes of the Income Tax Act (Canada) (the “Act”) from the recipient’s perspective. The taxpayer in this case is a Canadian public corporation that owned 19.9% of the common shares of Acanthus Real Estate Corporation (“Acanthus”). The taxpayer was unsuccessful with its unsolicited take-over bid for all of the remaining shares of Acanthus. Upon the failure of the taxpayer’s take-over bid, Acanthus paid a $7.7 million break fee to the taxpayer. The TCC held that the break fee should be treated on income account in the hands of the taxpayer.
For years prior to its attempted take-over of Acanthus, the taxpayer had been in the business of acquiring ownership and/or positions of control in real estate companies. It had successfully acquired significant interests in a number of real estate companies, and by early 2000 it held direct or indirect interests in properties comprising over 38 million square feet with an aggregate value of over $3 billion. Among these interests was the 19.2% common share position in Acanthus, which was acquired by the taxpayer in 1998. The taxpayer’s initial position in Acanthus was subsequently increased to 19.9%.
In 2000, the taxpayer attempted to acquire the balance of the shares of Acanthus by way of an unsolicited take-over bid at $8.00 per share. Negotiations followed, and the taxpayer entered into a pre-acquisition agreement with Acanthus to acquire the balance of its shares at $8.25 per share. The agreement provided, among other things, that: (i) Acanthus would not solicit other bids; (ii)Acanthus would recommend acceptance of the taxpayer’s bid unless a more favourable bid was received; (iii) Acanthus would waive its shareholders rights plan which included a poison pill; and (iv) Acanthus would pay a break fee of $4.7 million to the taxpayer if a better offer was received from a third party and the Board of Directors of Acanthus withdrew its support for the taxpayer’s bid and approved or recommended a new bid to its shareholders.
On the same day that the taxpayer’s take-over bid circular was mailed to the shareholders of Acanthus, CADIM, a company owned by the Caisse de dépot et placement du Québec, made an unsolicited competing bid at $8.50 per share, which was shortly thereafter revised to a bid of $8.75 per share. Acanthus notified the taxpayer that it would support the revised bid and paid the $4.7 million break fee to the taxpayer.
The taxpayer advised Acanthus that it was prepared to revise its bid price per share in response to CADIM’s bid. Acanthus and the taxpayer agreed to amend the pre-acquisition agreement to provide, among other things, that: (i) the bid price would be increased to $9.00 per share; (ii) the break fee would be increased to $7.7 million; (iii) any superior offer from a third party would have to be for at least $9.30 per share; and (iv) the taxpayer would have the right to match any superior offer. The $4.7 million break fee was returned to Acanthus by the taxpayer upon signing of this amended agreement.
CADIM further increased its offer price to $9.30 per share. The taxpayer decided that it would not revise its offer price but would seek to maximize the price for which it would support and sell its Acanthus shares to the third party. CADIM’s bid price was increased to $9.40 per share as a result of negotiations. The taxpayer agreed to tender its shares of Acanthus to CADIM at this price and Acanthus paid the $7.7 million break fee to the taxpayer.
TCC Analysis and Decision
The issue before the TCC was whether the break fee should be treated for tax purposes as (i) a non-taxable capital receipt, (ii) a taxable capital receipt, or (iii) a receipt on account of income in the hands of the taxpayer. The TCC began its analysis by expressing the view that, based on the facts and evidence, it was absolutely clear that the break fee was negotiated and received by the taxpayer “as an integral part of, and in the ordinary course of, its regular commercial business operations and activities.”
Non-Taxable Capital Receipt
The taxpayer’s primary contention was that the break fee was a non-taxable capital receipt. Non-taxable capital receipts are otherwise known as “windfalls” and involve a conclusion that the receipt did not constitute income from a “source”. The “source” concept underlies the primary charging provisions of the Act such that income considered not to be from a source is not subject to tax either on account of capital or on account of income.
The analysis of whether a receipt is considered a non-taxable capital receipt involves the application of seven factors outlined by the Federal Court of Appeal in The Queen v. Cranswick (82 DTC 6073). The TCC in Morguard found that the break fee paid to the taxpayer failed five of the seven factors: there was an enforceable claim to the payment; there was an organized effort to receive the payment; the receipt was sought after or solicited; the payment was expected to be received; and the payment was in consideration of, or in recognition of, property, services or anything else provided by the taxpayer either as a result of any activity or pursuit of gain carried on by the taxpayer or otherwise. Each of these five factors weighed in favour of a conclusion that the receipt of the break fee was not a windfall for the taxpayer.
The TCC noted that the remaining factor concerning whether there was any foreseeable element of recurrence “could be argued both ways since break fees are a normal part of contested and friendly take-over bids.” With respect to the remaining factor regarding whether this was a customary source of income of the taxpayer, the TCC was of the view that it could at least be argued that “similar break fees were a customary potential source of income given Morguard’s business acquisition strategy.” After having considered and balanced all of the factors outlined in Cranswick, the TCC concluded that it was clear in this case that the break fee was not a non-taxable windfall in the hands of the taxpayer.
Income vs. Capital Receipt
The TCC acknowledged the difficulty in differentiating between capital and income receipts, noting that there is no “bright line” test and that results can be unpredictable. The TCC viewed several facts in this case as particularly relevant to the income versus capital characterization.
According to the TCC, the potential or actual receipt of break fees could be viewed as “expected incidents” – however occasionally actually received – of the real estate acquisition business carried on by the taxpayer. The TCC considered the break fee in this case to have been received by the taxpayer in the course of its business and commercial activities in the same way as dividends, rents or management fees might be received. Furthermore, the increase of the break fee from $4.7 million to $7.7 million during the negotiating process was, in the TCC’s view, a clear indication that the potential of receiving the break fee “had become an integral, if perhaps secondary, purpose of the pre-acquisition agreement.”
The TCC’s analysis was guided by the Supreme Court of Canada’s reasoning in the Ikea Ltd. v. Canada (98 DTC 6092) case regarding the income versus capital characterization of tenant inducement payments in the hands of landlords. The TCC stated that there was “no greater linkage to a capital purpose in this case” than there had been in Ikea, where a tenant inducement payment was not considered to be linked to the capital purpose of assembling long-term leaseholds but to Ikea’s ordinary business operations.
The TCC confirmed its approval of the modern common sense business approach adopted by the Courts in the BJ Services Co. Canada v. R. (2003 TCC 900), International Colin Energy Corp. v. R. (2002 DTC 2185 (TCC)) and Boulangerie St-Augustin Inc. v. R. (95 DTC 164 affirmed (1996), 97 DTC 5012 (FCA)) cases to the income versus capital characterization of certain payments made in the context of unsuccessful attempted acquisitions. In the BJ Services Co. Canada case, the TCC characterized a break fee paid by a target corporation to be part of the regular day-to-day business of a public corporation and therefore deductible.
FCA Analysis and Decision
The taxpayer appealed the TCC’s decision in Morguard to the Federal Court of Appeal (the “FCA”). The taxpayer conceded on appeal that the break fee was not received as proceeds of disposition of capital property. Therefore, the issue to be decided on appeal was whether the break fee was an income or non-taxable capital receipt. The taxpayer’s position was based primarily on its disagreement with the TCC’s finding that the taxpayer was “essentially in the business of doing acquisitions and take-overs.” The taxpayer argued that the TCC’s decision contradicted the FCA’s decision in Neonex International Ltd. v. Canada (89 DTC 6339 (FCA)) which, according to the taxpayer, is authority for the proposition that the acquisition of capital properties cannot be a business in itself.
The FCA rejected the taxpayer’s argument and dismissed the appeal. It held that the decision in Neonex was based on the factual findings of the trial judge in that case, and did not establish a rule of law that the acquisition of capital properties can never be a business in itself. The FCA also endorsed the TCC’s analysis and application of the principles in Ikea and agreed that Ikea is the leading case on the characterization of extraordinary or unusual business-related receipts.
Takeaways from Morguard Decision
The TCC’s analysis in Morguard of the tax treatment of break fees, as endorsed by the FCA, could apply to future cases where break fees are received by taxpayers whose commercial activities and strategies regularly involve take-overs and acquisitions. However, the TCC indicated that a different analysis may be required where the break fee is received by a taxpayer whose regular commercial business activities do not involve acquisitions and take-overs. The TCC gave as an example the situation of a white knight sought by a reluctant target in response to an unsolicited or hostile bid. It would appear that a break fee may be characterized differently in the hands of a white knight. This is consistent with the historical treatment of court cases involving an income versus capital characterization, whereby such a characterization is largely dependent on the particular facts and circumstances of each individual case.
Interestingly, the TCC pointed out that break fees are generally accepted as being fully deductible business expenses to the payor based on the modern approach discussed above, but declined to place express reliance on this fact for the TCC’s conclusion that the break fee in this case should also be considered received on account of income. There is a certain intuitive symmetry in treating an amount consistently as either income or capital in the hands of both the recipient and the payor. However, this is at most the starting point of the analysis, and is in no way determinative of the result in every case. An independent analysis must be undertaken with respect to the recipient of a payment, and it is entirely possible for the same payment to constitute a deductible business expense to the payor but a capital receipt to the recipient.