What about the costs?

By John Giakoumakis
Illustration: Susanna Denti

When acquisition plans go off the rails, all costs are not treated the same for tax purposes

Mergers and acquisitions are a mainstay in today's business environment. Whether the purpose is for growth or as a strategy for survival, often companies move beyond their domestic borders to expand and improve profitability. In such transactions, acquiring corporations will typically expend significant time and money, the magnitude of which de-pends on the size and complexity of the proposed transaction and the duration of the process. Expenses include fees for investment bankers, consultants, lawyers and accountants. In the case of a failed or aborted acquisition, the acquiring corporations must also deal with the tax treatment of costs incurred.

Like the classic struggle between good and evil in movies, tax has its own battle, namely the question of characterization between income versus capital. Only expenditures on account of income are currently deductible, whereas expenditures on account of capital are available as an offset to capital gains; are currently deductible only if specifically permitted in Canada's Income Tax Act; or may qualify as eligible capital expenditures (ECE). Often in an active business context, capital gains are atypical and therefore capital losses are difficult to utilize.

Section 9 of the act is the starting point for the deduction of general business costs and states that "a taxpayer's income for a taxation year from a business or property is the taxpayer's profit from that business or property for the year." Paragraphs 18(1)(a) and (b) operate to limit the deductibility of expenses under Section 9. Paragraph 18(1)(a) prohibits the deduction of expenses that are not incurred for the purpose of earning business or property income, whereas paragraph 18(1)(b) prohibits the deduction of capital-type expenses except as expressly permitted elsewhere in the act.
 
Paragraph 20(1)(b) allows the deduction of 75% of an ECE at 7% a year on a declining balance basis. Generally an ECE is an outlay or expense incurred in respect of a business, resulting from a post-1971 capital transaction, incurred for producing income, and not otherwise deductible by virtue of any provisions other than paragraph 18(1)(b). An ECE can also be described as a capital expenditure of an intangible nature.

Courts have held that an outlay will be on account of capital if its purpose or direct result is the creation of an asset or an enduring advantage. However, what appears to be a relatively simple concept becomes somewhat blurred on practical application.

In Bowater Power Co. Ltd. v. M.N.R. (71DTC5469) the taxpayer incurred costs  to determine whether existing power stations could be expanded and to ascertain the feasibility of constructing power facilities at other sites. The Federal Court — Trial Division held that the expenses were currently deductible and noted it does not follow that merely because the expenditures were incurred for the purpose of ultimately bringing into existence a capital asset, reasonable endeavours to determine whether the capital asset should be created should always be considered as capital and, therefore, not deductible. The court noted such undertakings "may still result from the current operations of the business as part of the everyday concern of its officers in conducting the operations of the company in a businesslike way."

The reasoning in Bowater was followed in Kruger Pulp & Paper Ltd. v. M.N.R. (75DTC245) and Wacky Wheatley's TV & Stereo Ltd. v. M.N.R. (87DTC576). In Kru-ger the taxpayer incurred feasibility and other expenses to determine local timber availability and to obtain government licenses to cut such timber in connection with a proposed construction of a news-print plant. Due to various difficulties, the plant was never constructed and the timber licenses expired. The Tax Review Board held that expenses incurred in contemplation of an expansion of the taxpayer's business were currently deductible even though a capital asset would be created. In Wacky Wheatley's, the taxpayer incurred expenses investigating an opportunity to expand its business into Australia. The Tax Court of Canada held that the expenses were antecedent to any business decision to enter the Australian market and were part of the current expenses of the taxpayer's operations. In the court's view, expansion into new markets was an ongoing concern and part of business and commercial realities.

In D. Morgan Firestone v. The Queen (87DTC5237) and Neonex International Ltd. v. The Queen (78DTC6339), the taxpayers incurred expenses to determine whether to acquire existing operating companies and businesses to include these as part of a conglomerate of companies. In both cases, the Federal Court of Appeal emphasized that the acquisition of existing businesses with a view of holding them did not constitute a business and held that, since the related expenses were incurred for the purposes of acquiring capital assets, they were capital expenses. Unlike the taxpayer in Firestone, the taxpayer in Neonex operated an electric sign and outdoor advertising business. However, the court held that the acquisition of companies in unrelated businesses to form a conglomerate was not itself a business.

In Brooke Bond Foods Ltd. v. The Queen (84DTC6144), the Federal Court — Trial Division upheld the minister's assessment that expenses incurred by the taxpayer in respect of a building project that was subsequently abandoned were on account of capital, specifically ECE, and noted the abandonment did not alter the nature of the expense. The court distinguished this case from Bowater in that there was a plan to construct the building and the taxpayer was not involved in the purchase and sale of real property or trying to generate rental income. In contrast, the taxpayer in Bowater continuously evaluated the avail-ability of energy resources and development methods.

More recently in Rona Inc. v. The Queen (2003DTC979), in connection with the ac-quisition of shares of competitors' corporations, joint venture interests and assets, the taxpayer incurred legal, accounting, consulting, broker and real estate fees related to due diligence, valuation and other studies. The minister had denied deduction, adding the expenses to the capital cost of assets or treating these as ECE. The issue before the court was whether these costs were income or capital. The taxpayer's business plan was one of location expansion and increase in market share in order to deal with the arrival of giant competitors. Some projects were abandoned. The Tax Court of Canada observed that the advantage sought by the taxpayer through its growth strategy was the lasting expansion of its business structure, which under the scenarios of the acquisition of superstores as corporate stores and the acquisition of competitors was permanent in nature. The recurrence of such expenses as part of a planned phase of expansion over a lengthy period did not mean they should be treated as current. The court noted if fees involve the expansion of the business structure, they are capital outlays. For projects that were abandoned, the court observed there was no asset to capitalize costs to and the answer to the question of income or capital is provided by the Firestone case. The court concluded that the abandonment of certain projects does not change the nature of the amounts that would have otherwise been considered capital outlays and included in the acquisition cost of shares or assets. The court held that all the fees paid by the taxpayer to acquire sales outlets constituted capital expenses and weren't currently deductible. The taxpayer in Rona has appealed.

In Technical Interpretation 2002-0151405 issued on March 5, 2003, CRA considers the treatment of transaction costs of lawyers, investment bankers and accountants incurred by a purchaser in an aborted share or asset acquisition. In the CRA's view, the Bowater and Kruger cases do not apply, as the taxpayers incurred expenses in the course of investigating expansion opportunities relating to an existing business and the principles expressed therein do not extend to situations involving the acquisition of a separate business or business entity. In the case of an unsuccessful acquisition, the costs will generally be accorded the same character as if the acquisition had been successful, namely capital. On the question of whether ECE treatment applies, the CRA refers to Interpretation Bulletin 143R3, which states the income-purpose test will not be satisfied where fees are incurred in respect of aborted attempts to acquire shares but that the CRA will accept that these fees qualify as ECE if it can be demonstrated that the taxpayer intended to make the target's business part of a similar business that the taxpayer operates. A plan to amalgamate with or wind-up the target after the acquisition will be generally accepted as evidence.

The CRA's position is reiterated in Technical Interpretation 2002-0151455 issued March 5, 2003. It considers transaction costs incurred by a purchaser prior to a commitment to proceed with an acquisition with alternative scenarios of subsequently deciding not to acquire shares or assets, deciding to acquire assets, and deciding to acquire shares with or without a subsequent wind-up of or amalgamation with the target. Fees are generally considered capital with ECE treatment dependent on whether the target's business is to become part of a similar business. Feasibility studies and similar expenditures incurred to determine whether the taxpayer should expand an existing business and made as part of ordinary business operations are deductible.

The CCRA has clearly stated its position and taxpayers are facing an uphill battle. The best that can be hoped for is ECE treatment, which eliminates the ability to deduct 25% of costs and affords taxpayers a very slow annual writeoff. Only in situations of general feasibility endeavours with no specific target is income treatment possible. It appears that once a target is identified, any hope of deductibility evaporates. Even for ECE treatment, taxpayers have to demonstrate, based on their specific facts and circumstances, a planned assimilation of a similar business. In comparison, for accounting purposes, direct and incremental costs incurred in connection with a proposed transaction are expensed if the transaction is abandoned.

The position of the CCRA is punitive and inconsistent with ordinary fairness and business realities. In cases of failed or aborted transactions, there are no enduring benefits or capital assets acquired. The decisions in cases such as Bowater, Kruger and Wacky Wheatley's are in tune with such realities. The business environment that large companies operate in, to a very significant extent, dictates their behaviour. Competitive conditions often prescribe a philosophy and strategy of expansion and the inability to deduct related costs may be inhibitive. The costs of such strategies are costs of doing business and should be fairly treated as currently deductible costs in unsuccessful situations.

John Giakoumakis, CA, is director, corporate tax, with Barrick Gold Corporation in Toronto

Technical editor: Michel Lanteigne, FCA, managing partner, tax for Canada, Ernst & Young LLP