AbbVie Wins in Tax Court for Break Fee Deductibility

On June 17, the U.S. Tax Court ruled in favor of the taxpayer in AbbVie Inc. v. Commissioner, affirming the company’s right to treat a $1.6 billion break-up fee as an ordinary loss deduction rather than a capital loss under IRC Section 1234A(1). This outcome not only reinforces critical principles of tax characterization but also underscores the favorable tax implications associated with ordinary losses.

Background

In July 2014, AbbVie, a U.S. corporation, entered into a proposed merger agreement with Shire plc, a foreign corporation. The companies executed a cooperation agreement that included a provision obligating AbbVie to pay a termination, or “break-up,” fee to Shire if AbbVie’s board withdrew its support for the merger. That situation materialized in October 2014 following adverse IRS guidance regarding inversion transactions, prompting AbbVie to terminate the deal and pay Shire a $1.6 billion fee.

AbbVie reported the fee as an ordinary business deduction on its 2014 federal income tax return. The IRS, however, challenged the deduction, arguing that the payment should be classified as a capital loss under IRC Section 1234A(1), a provision intended to prevent taxpayers from converting capital transactions into ordinary losses via contract terminations. This change resulted in the IRS issuing AbbVie an approximately $572 million deficiency notice in December 2022.

AbbVie wins in Tax Court

The Tax Court granted AbbVie’s motion for summary judgment, rejecting the IRS’ position that the break-up fee was a capital loss. The court found that AbbVie’s obligations under the agreement primarily involved the performance of services such as obtaining regulatory approvals and recommending the merger transaction to shareholders, rather than having any rights or obligations to transfer property.

The court concluded that “[i]t was not AbbVie’s failure to complete the combination that triggered the liability; instead, it was the failure of AbbVie’s board to recommend the combination to AbbVie’s shareholders.” Because the agreement did not involve property interests (such as rights to buy or sell shares), IRC Section 1234A(1) was deemed inapplicable. The break-up fee was tied to AbbVie’s failure to recommend the transaction, not to the sale or acquisition of any capital asset. Generally, the payment was related to a terminated service agreement, not a property transaction, thus qualifying as an ordinary loss under IRC Sections 162 and 165.

Character matters: Ordinary versus capital losses

The decision is significant because ordinary losses are treated more favorably under the tax code than capital losses. Ordinary losses can offset both ordinary income and capital gains without limitation. In contrast, corporate capital losses can only offset capital gains, and unused capital losses must be carried back or forward to other tax years and expire after five years. By classifying the break-up fee as an ordinary loss, AbbVie obtained an immediate and substantial deduction against its 2014 income, reducing its overall tax liability by hundreds of millions of dollars.

Crowe observation

The ruling clarifies and limits the scope of IRC Section 1234A(1), ensuring that it does not apply to service-based contractual obligations, even those tangentially related to capital transactions like mergers.

Looking ahead

This victory for AbbVie sets the stage for broader implications for corporations engaging in complex M&A transactions. It affirms that break-up fees arising from service-related obligations, even in the M&A context, may rightfully be deducted as ordinary business losses, offering a more advantageous tax position and shielding companies from the limitations of capital loss treatment. Although the IRS still could appeal the decision, taxpayers active with M&A transactions should consult their tax advisers to determine if this favorable ruling impacts prior or current transactions.