The Tax Court of Canada has recognized in a recent case that “oversight expenses” – notably investment banking and other professional advisory fees for services rendered to boards of directors in their discharge of oversight responsibilities should be fully deductible, even in the context of a planned M&A transaction. The Canada Revenue Agency has traditionally taken a hard line on expenses incurred by an acquirer or a target and has denied deductibility on the basis that these expenses are of a capital nature. Under CRA’s position, such expenses have had limited to no practical tax benefit. By rejecting CRA’s position, the Rio Tinto Alcan Inc. v The Queen (2016 TCC 172) decision has delivered a significant victory for companies, especially given the magnitude of fees associated with M&A transactions. Oversight expenses accepted as deductible by the Tax Court in Rio Tinto Alcan included investment banking fees for financial modelling and for financial and valuation opinions culminating in a fairness opinion. Moreover, given the broad rationale adopted by the Court, this case potentially establishes the basis for deductibility of oversight expenses in other capital transactions such as reorganizations and financings [at para 88]:
“Simply put, Oversight Expenses are current expenses because they relate to the management of a corporation’s income-earning process. Proper management includes the judicious allocation or reallocation of capital for the purpose of maximizing the income earned by the corporation. Ineffective oversight over the capital allocation process is a formula for disaster that often leads to a decline in earnings and cash flow and, as a result, the destruction of shareholder value….Oversight Expenses serve an income-earning purpose.”
The Tax Court also analyzed some specific statutory provisions pleaded by the appellant as alternative bases for deduction. It found that a majority of the investment banking fees were deductible as expenses for advice as to the advisability of purchasing specific shares (which in this case were all of the shares of the target) and were not a commission, even though elements of the fee were contingent on milestones being achieved. Similarly, legal fees for competition hearings were deductible as costs of representation. These fees can also be substantial in a large multi-jurisdictional M&A transaction that may involve, as this case did, mandated divestitures of assets, often necessitating a spin-out or other reorganization.
Not all expenses associated with M&A and other capital transactions will be fully deductible as oversight expenses – those fees primarily linked to the execution of a capital transaction will continue to be treated as non-deductible capital outlays, except to the extent of any specific statutory deduction, such as certain financing amounts. Fees that were not deductible as oversight expenses in Rio Tinto Alcan included investment banking fees for active negotiations with the target, and fees for government relations and PR advice in the target’s home country (France). Because the evidentiary burden is on taxpayers to prove deductibility, companies should draft engagement letters for investment bankers, lawyers and other professional services firms with a clear demarcation between the deliberation and implementation phases of a transaction and should set expectations of advisors to clearly allocate their fees –”engaged re Project Code Name” will not suffice. With a little care up front, companies will be able to deduct substantial fees incurred in M&A and potentially other transactions that would previously have been denied by CRA.