By Nicole Paulsen and Danielle le Roux (DLA Cliffe Dekker Hofmeyr Tax Alert)
Executive summary (SAIT Technical)
The Canadian Federal Court of Appeal (FCA) recently delivered its judgment in the case of Morguard Corporation v The Queen 2012, TCC 55. A "break free" was received in return for withdrawing from a take-over bid and the FCA had to decide whether it was in income or capital receipt.
A break fee is a fee paid by a target company to bidders, during an acquisition, if the pending deal is terminated.
The court concluded that the break fee had become an integral, if perhaps secondary purpose, of the pre-acquisition agreement and the subsequent renegotiation agreement, thus rendering it a receipt of a revenue nature.
The Canadian Federal Court of Appeal (FCA) was recently tasked with deciding whether a 'break fee' received in return for withdrawing from a take-over bid was an income or capital receipt.
The case ofMorguard Corporation v The Queen 2012, TCC 55, was an appeal from the assessment made under the Canadian Income Tax Act RSC 1985 (CITA) that the break fee received by the Appellant taxpayer constituted a revenue receipt.
The Appellant was a Canadian public corporation. The Appellant and its affiliates were in the automotive parts and industrial products distribution business. After many years, it decided to exit the business, selling its automotive holdings for cash and using the cash proceeds to acquire control and ownership positions
in a number of real estate companies that owned and managed residential and commercial rental properties. The Appellant started to implement its business strategy by acquiring controlling positions in a number of real estate companies.
After numerous successful take-over bids, in June 2000, the Appellant launched an unsuccessful take-over bid for a corporation known as Acanthus Real Estate (Acanthus). During negotiations it lost the target in its take-over battle and as a result, sold nearly 20% of its previously acquired position in Acanthus. It receiveda $7.7 million break fee, as per the amending agreement to a pre- acquisition agreement signed between the Appellant and Acanthus.
The issue before the court was whether the break fee received by the Appellant in respect of its unsuccessful acquisition, should be characterised as an income receipt or capital receipt. The Appellant argued that the break fee should be classified as a non-taxable capital receipt. The counsel for the Crown argued that the break fee was an integral part of, and received in the ordinary course of, the Appellant’s commercial business operations, thus constituting a revenue receipt.
The court turned to the FCA case ofThe Queen v Cranswick,  1 F.C. 813, 82 DTC 6073, in order to determine whether the break fee constituted a windfall capital receipt that was not subject to tax. Applying the seven factors elucidated in this case, the court found that there is no doubt, having considered and balanced the factors inCreswick, that the Appellant did not receive a non- taxable windfall.
Secondly, the court considered the question of capital versus revenue. From the outset the court acknowledged that Canadian law, not unlike its South African counterpart, does not recognise a single infallible test in determining the capital or revenue nature of a receipt.
The court emphasised the necessity of considering decisions handed down in previously decided cases dealing with essentially similar payments. Applying this principle, the court based its
decision mainly on theIkea Limited v Canada  1 S.C.R. 196, 98 DTC 6092case, which effectively found that the issue to be decided is whether the amount received is linked to the capital purpose or whether the receipt was a necessary incident of the conduct of the Appellant’s business. In the present instance, the court found that the break fee was an amount received in the course of the Appellant’s business, commercial activities and its chosen business structure and strategy in a similar way as dividends, rent or management fees may be received.
The court further acknowledged that it is settled under the modern Canadian view of characterising business income, that break fees are ordinarily deductible business expenses to the payor. Therefore what needs to be addressed is whether such fees constitute ordinary business income to the recipient. This then, is clearly addressed through the application of the principles in the Ikea case mentioned above.
In applying the abovementioned principles, the court concluded that the break fee had become an integral, if perhaps secondary purpose, of the pre-acquisition agreement and the subsequent renegotiation agreement, thus rendering it a receipt of a revenue nature.