On February 24, 2012, the Tax Court of Canada ("TCC") rendered its decision in Morguard Corporation v. Her Majesty the Queen (2012 TCC 55 – PDF) on the issue of the taxation of break fees received in the context of a takeover bid pursuant to a "lock-up agreement". The Court held that in the particular circumstances of the case the break fees were taxable to Morguard Corporation ("Morguard") as ordinary income.
The precise issue that the Court addressed was whether a break fee of $7.7 million received by Morguard pursuant to a lock-up agreement should be characterized as an income receipt or a capital receipt, and if it was a capital receipt, whether it was a capital gain or a non-taxable capital receipt akin to a windfall.
Morguard had been in the automotive parts and industrial products distribution business. Prior to the 2000 takeover bid in question, Morguard had divested that business and had decided to concentrate on the business of acquiring controlling ownership positions in a number of real estate companies that owned and managed residential and commercial rental properties.
Prior to the 2000 year which was in issue, Morguard had acquired a 20% equity interest in a public real estate corporation, Acanthus Real Estate Corporation ("Acanthus"). In June 2000 Morguard made an unsolicited takeover bid for the remaining shares of Acanthus for a price of $8 per share. After negotiating with the Special Committee of the Board of Directors of Acanthus, Morguard and Acanthus entered into what is commonly referred to as a lock-up agreement which provided that the Board of Acanthus would support a revised bid of Morguard for $0.25 more per share in return for which Acanthus agreed not to solicit other bids and to recommend acceptance of Morguard's bid to its shareholders unless a more favourable bid was received and, in addition, a break fee of $4.7 million was negotiated "if a better offer was received from a third party and the Board of Directors of Acanthus withdrew its support of [Morguard's] bid and approved or recommended the new bid".
CADIM, a company owned by the Caisse de dépot et placement du Québec ("CADIM"), was also interested in acquiring Acanthus and made unsolicited bids that were for a larger amount than Morguard's bid. What was described as "vigorous auction-type bidding" followed in terms of bids by Morguard and counter-bids by CADIM. Morguard then negotiated further with Acanthus and agreed to make an increased bid of $9.00 per Acanthus share. It was further agreed that any superior offer by a third party would need to be for at least $9.30 per share, that Morguard would have the right to match any such offer, and that the break fee was increased to $7.7 million. When CADIM went to a bid of $9.30 per Acanthus share, Morguard switched strategies and determined that it would not match this bid but wished to maximize the price for which it would "support and sell" its 20% position in Acanthus. In this regard the CEO of Morguard contacted the CEO of CADIM and negotiated a revised bid of $9.40 per Acanthus share at which price Morguard agreed to support the bid and sell its 20% holding into that bid.
CADIM's $9.40 bid was duly made and the Board of Directors of Acanthus notified Morguard that it had determined that what had become the final bid of $9.40 per Acanthus share was a superior bid, that it was terminating the lock-up agreement and that it was forwarding to Morguard a certified cheque of $7.7 million in payment of the break fee. The sale of its 20% interest in Acanthus resulted in a gain to Morguard of approximately $5 million.
Morguard's primary position in the appeal was that it had received the $7.7 million break fee as a non-taxable capital receipt akin to a windfall. Reference was made to one of the leading cases on "windfall payments". Such cases have held that provided that a number of criteria are met, amounts received by a taxpayer that are unexpected and one-time payments can constitute non-taxable capital receipts in the nature of a "windfall" which are not includable in any category of "income" for purposes of the Income Tax Act (Canada).
The TCC found that, examining the criteria for such a non-taxable windfall payment, Morguard was unable to succeed in respect of the following criteria for a windfall: (i) no enforceable claim to the payment; (ii) no organized effort to receive the payment; (iii) the receipt was not sought after or solicited in any manner; (iv) the payment was not expected to be received; and (v) the payment was not in consideration of or in recognition of property, services or anything else provided or to be provided by Morguard either as a result of any activity or pursuit of gain carried on by the taxpayer or otherwise.
While it is well established that there is no "reciprocity" in the Act whereby an amount paid by a payor to a payee must have the same characterization to the payor for tax purposes as it has to the payee, at paragraph 38 of its judgment the TCC did appear to find it quite significant that based on prior jurisprudence it was now settled, at least as a general rule, that break fees such as those involved in the Morguard case were ordinary deductible business expenses to the payor.
The Court in Morguard rejected the idea that the break fee was some extraordinary and unexpected windfall of Morguard, even though it was the only such fee which it had received up to the time of the trial, and further rejected Morguard's argument that the break fee was received on capital account rather than on income account. At the relevant time, Morguard was essentially in the business of doing acquisitions and takeovers in order to diversify its business into real estate investments. Accordingly, the break fee which is an ordinary incident of such takeover bid negotiations and agreements was income to it as its ordinary business activities included attempting to make corporate acquisitions of which its bid for Acanthus was part. Morguard has appealed the TCC decision to the Federal Court of Appeal.
The result in the Morguard case if upheld on appeal may not necessarily apply to "break fees" received by a "white knight" bidder who comes into the bidding fray after the fact and after being solicited by the target. This may particularly be the case if such a white knight has not previously acquired companies through takeover bids and may be making its bid entirely or in large part because at the last bid price the target is perceived as undervalued. In such a situation if a higher bidder comes along and triggers payment of the break fee, the white knight will have additional arguments that a break fee it receives is a one-time event that it did not regularly pursue. Of course, such fees must obviously be negotiated by the white knight in order to be received which may be enough to take the fee out of the windfall category in the Court's view. This aspect must await further clarification by the Courts.