In a welcome decision for Canadian acquirors and targets, the Tax Court of Canada recognized, in Rio Tinto Alcan Inc. v The Queen,1 that certain oversight expenses—including certain investment banking and other professional advisory fees—should be deductible in the context of M&A transactions. This is particularly so where such services are provided to enable the board of directors of the acquiror or target to determine whether to proceed with the transaction. The Court also established a principled basis for the deductibility of transaction expenses in a far broader set of circumstances than those previously accepted by the Canada Revenue Agency (the CRA), in particular, in situations in which a board is discharging its oversight function prior to a decision to implement a particular transaction(s). The decision is under appeal; if affirmed, it will represent a significant expansion of the deductibility of transaction fees. The onus will remain on the taxpayer to prove the expenses are deductible based on the new criteria; engagement letters for advisors and their invoices, clearly demarcating oversight activities in respect of proposed transaction(s) from the implementation phases, should be prepared accordingly.
At issue in Rio Tinto was the deductibility to Alcan (the Canadian predecessor to Rio Tinto Alcan) of approximately $100 million in transaction expenses, including legal, investment banking, financial, and other professional advisory fees, incurred in the course of two related transactions—a public corporate acquisition of a French aluminum company and a related spin-off of certain assets as mandated by competition authorities as a condition of the public takeover. Consistent with the CRA’s historical position, the government (referred to as the Crown) argued that the expenses were not deductible on a current basis on the grounds that such expenses were incurred in the context of a capital transaction.2 Subject to certain statutory exceptions, capital expenses have limited immediate use to corporate taxpayers under Canadian tax law.3 In allowing a large proportion of the expenses to be deducted on a current basis, the Court rejected the CRA’s position, recognizing the importance of the board of directors’ oversight function on a corporation’s income-earning process.
Importance of the Board’s Oversight Function
Significant to the ultimate result of the case, the Court recognized the importance of the board of directors’ role in determining whether or not to proceed with a transaction and in allocating capital resources. Noting that ineffective oversight over the capital allocation process can lead to a decline of earnings and cash flow and that modern day shareholders demand scrupulous oversight, the Court acknowledged that effective oversight requires independent advice which the board relies on in approving a capital expenditure. The expenses incurred to facilitate this advice are not capital in nature—rather, they are integral to the corporation’s income-earning process.
This conclusion is consistent with prior case law that held that the Crown’s hardline view on expense deductibility was “fundamentally inconsistent with the economic and business realities of the world of mergers and acquisitions” and adding that “it is a basic common sense approach to view maximizing share price as inextricably interwoven with the business of any company”4 . The taxpayer was assisted in this regard by its evidence which showed that one of its business priorities was the maximization of shareholder value and that it has a long history of acquisitions and transactions entered into for increased revenues, earnings and economic value. Given that most companies, both public and private, would take such a position, the case represents a significant relaxation of the deductibility of M&A transaction expenses to businesses.
Oversight Expenses vs. Execution Costs: The Distinction
The Court drew a distinction between “oversight expenses,” which are expenses which assist the board in the decision-making process and in the fulfilment of its oversight function, and “execution costs,” which are expenses incurred as part of the implementation of a specific transaction or set of transactions leading to the acquisition of capital property. In analyzing the category into which a particular expense falls, the Court looks at the primary purpose of the work performed—were the expenses incurred primarily to assist in the oversight or management process or were they primarily linked to the implementation of a transaction carried out on capital account?
Oversight expenses, the Court held, are fully deductible on the basis that (i) they relate to the management of a corporation’s income-earning process, including the allocation of capital for the purpose of maximizing the income earned by a corporation and (ii) such expenses do not per se create an enduring benefit (a hallmark of a capital expense). In contrast, execution expenses are not currently deductible, in that they pertain to the actual implementation of an approved capital transaction that does create an enduring benefit.
The onus will be on the taxpayer seeking a deduction to adduce evidence showing that the expenses in question are properly classified as oversight expenses. The Court did, however, provide assistance to taxpayers by adopting, in the circumstances of Rio Tinto, a “bright line” date test for distinguishing between the two categories. Specifically, the Court endorsed a distinction based on whether or not there was a binding commitment to proceed with the project in question. Expenses incurred prior to formally entering into the transactions were deductible as oversight expenses since the taxpayer was aggressively involved in the pursuit of increased shareholder value on a “frequent and recurring” or continuous basis. Although not discussed in the case, the analysis therein suggests that the oversight expenses should continue to be fully deductible, even if a transaction is not successful.
Once a framework for negotiations had been established, however, expenses incurred in the context of active negotiations were more closely linked with the implementation of the transaction and hence constituted “execution costs.”
Examples of Deductible Oversight Expenses
Within the framework described above, the Court in Rio Tinto then considered the specific deductibility of a number of different transaction costs, which broadly fell into five categories: (1) investment advice; (2) public relations; (3) legal and accounting advice; (4) printing and issuance of documents; and (5) representations to government authorities.
With respect to the acquisition, the Court held that certain investment advisory fees were deductible when they were incurred during the deliberation phase of the deal, including fees for financial modelling and for financial and valuation opinions culminating in a fairness opinion. In this respect, the Court was persuaded by the fact that the fairness opinion was necessary to demonstrate that the directors acted with due care in approving the transaction. On the other hand, investment advisory fees incurred in the context of active negotiations and in connection with price negotiations were not deductible, as they were more closely linked to the implementation phase.
With respect to the spin-off, the Court allowed the deduction of investment advisory fees incurred prior to final approval of the transaction. More specifically, out of 389 days spent on the transaction, 345 days predated final approval. Thus 88.69% of the fees were deductible from income.
As an alternative basis for deduction, Alcan raised a provision of the Canadian Income Tax Act that expressly allows for the deduction of certain investment advisory fees incurred for advice as to the advisability of purchasing specific shares. The Court indicated that the fees found to be deductible under the analysis described above would also be deductible under this alternative provision. While the provision does not apply to fees that are a “commission,” the fees in this case were fixed prior to the completion of the transaction. The fees that were found to be implementation costs, however, were still not deductible on the alternative basis.
In contrast, the Court held that public relations fees did not constitute oversight expenses. The evidence showed that such expenses were necessary for the smooth implementation of the transaction, due to the need for careful and strategic communication with the public since the takeover was politically sensitive in France. Query if public relations expenses or communication expenses incurred in the deliberation phase could be deductible as oversight expenses. Printing costs for the preparation and delivery of documents that were legally required were also not oversight expenses as the preparation and delivery of the documents was an essential step in the implementation of the transactions. Notably, certain fees were not deductible due to insufficient evidence describing the nature of the fees, reminding all taxpayers of the necessity to adduce sufficient evidence.
The case demonstrates that significant transaction fees can be deducted on a current basis under Canadian tax law, with proper management and careful maintenance of records. Recognizing that the taxpayer will in all cases bear the onus of proving deductibility, corporations and their boards of directors should take care in documenting all board meetings considering potential transactions to demonstrate that board oversight is part of the everyday business of the corporation. Given the benefit, from a tax perspective, of characterizing an expense as an oversight expense, care should be taken to allocate expenses to ensure that there is a demarcation between the deliberation and implementation phases of a transaction. Expenses that pertain to advice given to the board of directors to assist it in the decision-making process undertaken as part of the exercise of the board’s oversight function should, ideally, be subject to separate retainer agreements and, in all events, clearly identified as such in any invoices.
Transaction fees associated with M&A transactions can be substantial, particularly in the case of transactions with multi-jurisdictional components and those involving pre- and post- closing reorganizations required to meet conditions related to the mandated divestiture of assets or the rationalization and integration of operations. The decision in Rio Tinto is therefore a welcome development in Canadian tax law. ■
2 Paragraph 18(1)(b) of the Income Tax Act (Canada) precludes a deduction for an outlay or expense made or incurred on account of capital.”
3 The Crown argued that the expenses incurred in connection with the corporate acquisition should be added to the tax cost base of the shares acquired and that the expenses incurred in connection with the spin-off should be deducted from the proceeds of disposition received.