Tax and industry professionals have been waiting for the Federal Court of Appeal (the “FCA”) to issue its decision in Glencore Canada Corporation v R for several months. The decision under appeal (2021 TCC 63) sparked many discussions, and the FCA’s reasons for dismissing the taxpayer’s appeal (2024 FCA 3) are sure to spark many more.
The FCA determined that “break fees” paid by a target company to a would-be acquirer were taxable not as capital gains but as an “inducement” received “in the course of earning income from a business or property” under paragraph 12(1)(x) of the ITA. Taxpayers engaging in M&A transactions involving break fees should take note of Glencore, particularly if the break fees were added to motivate a bid from a reluctant offeror.
Background
In 1996, Falconbridge Limited (Glencore’s predecessor) sought to acquire shares of Diamond Fields Resources Inc. (the “Target”). Falconbridge made an offer and entered into an Arrangement Agreement to purchase the Target’s shares, but the Target backed out of the deal when Inco Ltd. made a competing offer.
The Arrangement Agreement entitled Falconbridge to break fees from the Target equal to approximately 2.5% of the purchase price of the shares. Glencore (Falconbridge’s successor) was reassessed on the basis that the break fees were taxable on income account. Glencore appealed that reassessment to the Tax Court, which dismissed Glencore’s appeal after finding that the break fees were taxable under section 9 as income from a business. The Tax Court found that the break fees were business income because they were “inextricably linked to Falconbridge’s ordinary business operations as a nickel mining company” and “[t]he potential acquisition… was part of Falconbridge’s strategy for earning income”.
The FCA found that the Tax Court had misinterpreted the test from Ikea Ltd. v Canada [1998] 1 SCR 196 (“Ikea”) when it asked, broadly, whether the break fees were linked to Falconbridge’s business. Ikea asks a narrower question: were the break fees inextricably linked to something on revenue account? In the FCA’s view, the break fees were linked to the acquisition of shares in a junior mining company—a capital asset. The fact that the transaction was part of Falconbridge’s strategy for increasing the profitability of its business did not automatically render the break fees income from that business.
Having overturned the Tax Court’s decision, the FCA went on to consider whether the break fees were an “inducement” included in income under paragraph 12(1)(x).
Capital gain or inducement?
(a) Not a capital gain
Before turning to paragraph 12(1)(x), the FCA briefly considered whether the break fees were taxable as capital gains. Glencore had argued that the break fees represented consideration for rights given up when the deal was cancelled—namely, the right to merge with the Target—and therefore were taxable on capital account and not taxable under paragraph 12(1)(x).
The FCA rejected that argument on the basis that Falconbridge never had a right to merge with the Target. Because the deal was always conditional on approval by the Target’s shareholders and board of directors, the FCA concluded that no “right” to merge existed. As a result, there was no disposition and no capital gain for tax purposes. The decision does not address whether Falconbridge disposed of other rights (i.e., rights amounting to less than an unconditional “right to merge”) arising under the Arrangement Agreement.
(b) Inducement
Paragraph 12(1)(x) applies to a wide range of payments, including grants, subsidies, forgivable loans, refunds, reimbursements, and other forms of inducements or assistance received in the course of earning income from a business or property. These payments are brought into a taxpayer’s income by paragraph 12(1)(x), which was introduced in the 1980s after the courts cast doubt on whether such extraordinary payments were taxable.
Break fees have been described as inducements by superior courts and securities tribunals in commercial contexts where they are offered to encourage a reluctant bidder to make an offer. The FCA saw a parallel between those cases and Glencore, finding that the break fees were paid to “entice” Falconbridge to make an offer despite the looming possibility of a competing bid. The break fees were thus an “inducement” within the meaning of s. 12(1)(x)(iii).
(c) “Received… in the course of earning income from a business or property”
To be taxable under paragraph 12(1)(x), an amount must be received “in the course of earning income from a business or property”. The FCA reasoned that the phrase “in the course of” signals a broad category that includes amounts received “in connection with”, “incidental to”, or “arising from” income earned from business or property. On this interpretation, the requirement was satisfied because the break fees were linked to Falconbridge’s operations as a nickel mining company. Alternatively, the break fees were received “in connection with” income from property because the shares had the capacity to produce income.
Takeaways
Break fees are a common feature of M&A transactions, but “enticement” may not be a common way of describing them.
In Glencore, the record showed that the Target actively sought to start a bidding war and that Falconbridge would not have participated without the break fees. The FCA interpreted paragraph 12(1)(x) as looking only at the motives of the payer, rendering Falconbridge’s perspective as recipient irrelevant to the nature of the payment.
However, not all break fees will have a history like those in Glencore. In many cases, break fees are negotiated to disincentivize a vendor from unilaterally backing out of a deal, not to entice the purchaser to make a bid. Paragraph 12(1)(x) demands a factual inquiry into the circumstances of the transaction and the commercial motivations of the parties involved, particularly the payer.
After Glencore, parties engaging in such transactions should consider documenting the purpose behind any negotiated break fees. Recipients of any payment that could be characterized as an “inducement” should exercise heightened caution to ensure the transaction is properly reported for tax purposes.
