In a precedential division opinion, the U.S. Tax Court ruled that AbbVie, Inc. correctly deducted the over $1.6 billion "break fee" paid as the result of an abandoned merger plan as an ordinary deduction. AbbVie Inc. & Subs. v. Commissioner, 164 T.C. No. 10. The Internal Revenue Service (IRS) argued that the break fee resulted in a capital loss under section 1234A, but the court held that section 1234A was inapplicable because AbbVie's obligations under the terminated contract were in the nature of services and there was no "termination of a right or obligation… with respect to property."

In July 2014, AbbVie and Shire plc announced that they had agreed on a proposed combination and executed a "Co-operation Agreement" to facilitate the combination. The Co-operation Agreement included an agreement by AbbVie's Board to recommend the merger to AbbVie's shareholders ahead of a shareholder vote on the proposed merger. The agreement provided that if AbbVie's Board did not recommend the merger to its shareholders, AbbVie would be obligated to pay Shire a break fee in a calculated amount that would turn out to be $1,635,410,676. After the issuance of IRS Notice 2014-52 in September 2014, inversion transactions like the proposed AbbVie-Shire merger became less attractive, and AbbVie's Board decided to not recommend the merger to its shareholders, triggering an obligation to pay the break fee. AbbVie claimed the amount paid to Shire as an ordinary deduction on its 2014 tax return and petitioned the Tax Court when the IRS asserted that the sum should instead be treated as a capital loss.

Section 1234A(1) provides that gain or loss "attributable to the cancellation, lapse, expiration, or other termination" of "a right or obligation... with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer" is capital gain or loss. The Tax Court considered the heart of the dispute in this case to be whether AbbVie's terminated obligations were "with respect to property" for purposes of section 1234A. The court decided they were not.

In the court's analysis, the crux of the Co-Operation Agreement was an agreement to provide services, namely, the Board's best efforts to convince shareholders to approve the proposed combination. It was not an agreement "with respect to property," as required by section 1234A, because AbbVie and Shire did not own the property that was at issue in the proposed combination (i.e., the shares of each company). Therefore, AbbVie had no obligations "with respect to" the relevant property at all, it was merely obligated to attempt to convince the actual owners of its stock that they should vote in favor of the merger. The court construed this as an obligation to provide services, rather than an obligation with respect to property.

Much of the court's analysis is an exercise in statutory interpretation: what does it mean for a right or obligation to be "with respect to property" for purposes of section 1234A(1)? The IRS argued that the Co-operation Agreement was "with respect to property" because it created a conditional obligation to acquire the shares of Shire. In rejecting the IRS's position, the court noted that "broad connecting phrases," such as "with respect to," "are necessarily limited by the context in which Congress uses them." The court opined that, based on this context and the legislative history, Congress' intent was to target "rights and obligations that, if not canceled or otherwise terminated, would have resulted in a capital transaction." Here, the court decided, if the Co-operation Agreement had not been terminated, AbbVie simply would have made a recommendation to its shareholders. It would be up to the shareholders — the actual owners of the property at issue — to decide whether the capital transaction should go forward. Because the court decided the Co-operation Agreement was not "with respect to" property and was outside the scope of transactions Congress enacted section 1234A to address, the break fee was properly deductible as an ordinary deduction, not as a capital loss.

The AbbVie case presented a specific structure and set of undisputed facts that, if altered slightly, may have led to a different outcome. Key aspects of the court's reasoning depend on the viability of interpreting a termination clause as relating to an obligation to provide services and not to sell property. Future cases applying AbbVie will be worth following. For example, the court noted that for section 1234A to apply, "at a minimum, the underlying transaction must have included (had the transaction in fact occurred) a direct or indirect transfer of a property interest to or from the taxpayer." This reference to indirect transfers is notable: how would it have affected the court's calculus if shareholder approval were a fait accompli, such as if a majority of the shares were owned by Board members, or if there was evidence in the record that the shareholders always went along with whatever the Board suggested? A future case might also turn out differently depending on the transaction structure and the powers of the entity that is obligated to pay a break fee: in AbbVie, the payor of the break fee was not the selling shareholder. 

Overall, the AbbVie case limits the reach of section 1234A(1), provides guidance to taxpayers in an area of law where guidance had been notably lacking, and evidences a potential roadmap to drafting termination clauses that support an ordinary deduction in the case that a proposed transaction falls through. While this is a win for AbbVie today, it will be worth monitoring whether the IRS files a Notice of Appeal by the mid-September deadline.

For more information, please contact:

Layla J. Asali, lasali@milchev.com, 202-626-5866

Tyler C. Jackson, tjackson@milchev.com, 202-626-5820

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