The Tax Court concluded that $65 million paid to terminate a merger contract was deductible under IRC § 162 or IRC § 165 and did not require capitalization under IRC § 263.
IRC § 162 allows a deduction for the ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business, while IRC § 165(a) allows a taxpayer a deduction for a loss sustained during the tax year and not compensated for by insurance or otherwise. On the other hand, IRC § 263(a) and the Supreme Court in Indopco Inc. v. Commissioner (503 U.S. 79 (1992)) disallow a deduction and require capitalization when a new or separate asset is created or the expenses incurred are linked to the acquisition of a long-term benefit. The determination of whether an expenditure is deductible or must be capitalized is generally a factual one.
Santa Fe Pacific Gold Co. (Santa Fe) was a mining company spun off in the 1990s from its parent railroad. Santa Fe soon faced a hostile takeover attempt by a larger mining company, Newmont USA Ltd. (Newmont). In an effort to avoid the hostile takeover, Santa Fe found a “white knight” in Homestake Mining Co. and entered into a merger agreement with Homestake that contained a $65 million termination fee to be paid if either party violated the agreement.
Newmont, however, persisted in its efforts to acquire Santa Fe by making increased offers. Santa Fe’s board determined it would breach its fiduciary duty if it did not at least consider the new offers. While doing so, Santa Fe unsuccessfully attempted to renegotiate more favorable terms for the termination fee with Homestake Mining. Furthermore, Newmont was not willing to pay the fee for Santa Fe as part of its proposed acquisition. Homestake declined to counter Newmont’s higher offer, which Santa Fe’s board accepted. Santa Fe paid Homestake the termination fee and deducted it on its 1997 tax return. The IRS disallowed the deduction, asserting that the expense had to be capitalized under IRC § 263.
The Tax Court noted that the Newmont merger was clearly a hostile takeover that Santa Fe sought to ward off and that it was trying to protect its growing business by its agreement with Homestake. The two agreements were separate transactions with different origins. Paying the fee did not create any significant long-term benefit to Santa Fe. In fact, after the acquisition, Newmont shut down Santa Fe’s operations. The court concluded that the payment was not subject to capitalization and was deductible under IRC § 162. Alternatively, the court said, the fee could be deducted under IRC § 165 as an abandonment loss, since Santa Fe was forced to abandon the proposed merger with Homestake when Newmont raised its offer.
It is important to note that in 2003, after the tax year at issue here, the Treasury issued final regulations (Treas. Reg. § 1.263(a)-5) addressing the treatment of amounts paid to facilitate an acquisition of a trade or business. The regulations were intended in part to provide bright-line rules and reduce controversy and are to be applied to amounts paid or incurred on or after Dec. 31, 2003. The regulations state that a series of transactions carried out as part of a single plan to acquire or reorganize a trade or business generally must be treated as a single transaction that must be capitalized. Furthermore, Treas. Reg. § 1.263(a)-5(c)(8) provides that if a termination agreement is mutually exclusive with a merger that must be capitalized, the termination agreement is treated as a second transaction for which expenses to facilitate it must also be capitalized. The transactions with Newmont and Homestake would seem mutually exclusive—that is, Santa Fe could not be acquired by both companies. By that reasoning, if the facts in Santa Fe arose today, these regulations would appear to require the termination payment to be capitalized. However, one commentator has disagreed with that premise, on grounds that the transactions were not necessarily mutually exclusive (Robert Willens, Daily Tax Report, BNA, April 30, 2009). Another, although agreeing with it, suggests the Tax Court might have ruled the way it did anyway (Jasper L. Cummings Jr., Tax Notes, Tax Analysts, June 8, 2009).
Santa Fe Pacific Gold Co. v. Commissioner , 132 TC no. 12
By Steven C. Thompson, CPA, Ph.D., Professor of Accounting at Texas State University, San Marcos, Texas.