Should I Stay or Should I Go: AbbVie Highlights Tax Considerations to Termination Agreement Payments

LAFA 20154701F
In most situations, the question of whether a contract relates to property is pretty straightforward. But financial innovation has pushed the boundaries of what can be considered “property.” For example, is the interest in the outcome of a civil litigation property? This issue was considered by the Internal Revenue Service (IRS) in a 2015 Legal Advice Filed Attorney (LAFA). In the LAFA, the IRS considered whether a taxpayer sold a capital asset (and potentially recognized tax-favored capital gains) when it received payments pursuant to an “agreement purporting to be the sale of an interest of a litigation claim.”

On the facts of the LAFA, the taxpayer purchased an interest in the right to receive a percentage of any settlement entered into by a party to a litigation. The taxpayer made payments to the litigant over time. Concomitantly, the litigant made a series of payments back to the litigation funder as it received litigation settlement payments. The issue considered in the LAFA is whether these payments of portions of the settlement payments to the litigation funder should be treated as capital gain or ordinary income.

The analysis employed by the IRS supports the conclusion that the contractual rights to receive a percentage of the settlement payments constitute property. The IRS held, however, that the receipt of periodic payments under the agreement was not a sale or exchange of property. Accordingly, the taxpayer did not have capital gains from its receipt of the periodic settlement payments.

The IRS next considered whether the periodic payments could generate capital gains under Code § 1234A. Specifically, the IRS considered whether the periodic payments terminated the taxpayer’s interest in the settlement payments purchased from the litigant. The IRS held that the payments were made pursuant to the terms of the purchase, not from a settlement of rights under the contract:

The mere receipt of a portion of that income by Taxpayer, whether received from [the litigant] or directly from [the litigation defendant], is not an amount realized from the disposition of Taxpayer’s rights, for purposes of section 1001, and therefore cannot be “gain” potentially subject to characterization as capital gain under sections 1222 and 1234A.

Thus, the LFA supports the conclusion that contractual rights over a transaction outcome can be treated as property for purposes of Code § 1234A. But the taxpayer failed to take advantage of this conclusion to generate capital gain because the transactions in which it earned income did not terminate those rights. Instead, the transaction performed according to its terms.

AbbVie v. Comm’r
In AbbVie v. Comm’r,^[i] the IRS really took to heart the conclusion that contracts over transaction outcomes are property. As analyzed below, the IRS took the position that a contract calling for a breakup fee if a business combination was not recommended by the board of directors of one of the parties was a contract over property. In this case, the Tax Court, however, did not agree that this was a contract over property.

Even in the context of well-capitalized public companies, $1.6 billion is a big number. So when AbbVie, Inc. promised to pay that amount to Shire plc if the AbbVie board of directors did not recommend a business combination between the two companies to the AbbVie shareholders, it was clear that the AbbVie Board believed it had a path to recommending the deal. But as we all know, “The best-laid plans of mice and men often go awry.”^[ii] And so it was in the case of the courtship of AbbVie and Shire, and when the Board did not recommend the transaction, AbbVie paid the $1.6 billion breakup fee to Shire.

AbbVie sought to deduct the breakup from its income as determined for U.S. federal income tax purposes. The IRS challenged the deduction on a novel ground. Specifically, the IRS sought to invoke the financial product rule of Code § 1234A to look through the payment, find the termination of a property right, and treat the payment as a capital loss. AbbVie, like most operating businesses, did not have sufficient capital gains to offset the loss as a capital loss. Accordingly, the IRS’s proposal effectively treated the $1.6 billion payment as nondeductible loss.

In July 2014, AbbVie and Shire entered into a “Co-Operation Agreement.” Under this Agreement, AbbVie was required to take a number of steps to create a non-U.S. holding company that would become the holding company for both of AbbVie and Shire. The Agreement provided, among other things, that if the AbbVie Board did not recommend the transaction to the AbbVie shareholders, AbbVie would be required to pay the breakup fee to Shire. AbbVie was obligated to pay the breakup fee if the transaction did not proceed for other reasons, as well.

In September 2014, the IRS issued Notice 2014-52,^[iii] stating that it would treat the proposed form of combination between AbbVie and Shire as an “inversion transaction.” Under the terms of the Notice, the AbbVie-Shire combination would not be grandfathered from this treatment. For our purposes, two facts are important. First, the treatment of the AbbVie-Shire combination as an inversion would have resulted in significant adverse U.S. federal income tax consequences to AbbVie. Second, the fact that the AbbVie Board chose not to recommend that transaction to the AbbVie shareholders because of the inversion rules was not a basis that would have excused AbbVie’s obligation to pay the breakup fee.

When the IRS and AbbVie could not agree on whether the breakup fee gave rise to an ordinary deduction or a capital loss, AbbVie filed a claim for refund in the Tax Court. The court began its analysis by citing cases that permitted ordinary deductions for abandoned capital transactions.^[iv] It then discussed the look-through of Code § 1234A and noted that this Code section was enacted to eliminate the fact that, in the absence of the look-through rules, taxpayers could effectively arbitrage the tax system by electing to treat gains as capital and losses as ordinary by performing on gain contracts and terminating loss contracts.

Code § 1234A treats gain or loss from a contract termination as capital when four requirements are satisfied:

1. There must be a recognized gain or loss;
2. The gain or loss must be attributable a “cancellation, lapse, expiration or other termination of a right or obligation;”^[v]
3. The terminated right or obligation must be with respect to property; and
4. The property subject to the contract (i.e., right or obligation) must be a capital asset in the hands of the taxpayer.

In AbbVie, the court held that the breakup fee was not paid with respect to property. Accordingly, the court refused to treat the fee as capital under Code § 1234A.

The Tax Court, following its approach in Varian Medical Systems v. Comm’r,^[vi] began with a linguistic inquiry into the meaning of the phrase, “with respect to” as used in Code § 1234A. While the court recognized that the phrase should be given a broad interpretation, it held that the phrase should be interpreted in the context of the statute. The statute was enacted to capture transactions that, if fulfilled, would have given rise to capital gains or losses. In addition, the Tax Court relied upon prior interpretations of Code § 1234A to support its conclusion. The court cited CRI-Leslie LLC v. Comm’r,^[vii] which applied Code § 1234A to agreements to buy or sell property, and Estate of McKelvey v. Comm’r,^[viii] which applied Code § 1234A to a deemed termination of a variable prepaid forward contract over publicly traded stock.

The court then sought to apply these rules to the Co-Operation Agreement. The court noted that the “Co-Operation Agreement “is not an agreement to buy, sell or otherwise transfer property.” Even if the subject matter could have been considered to be property, the power to transfer the property rested with the shareholders, regulators and a court overseeing the transaction. The Co-Operation Agreement did not give either the company or their boards the power to transfer property. Given these realities, the court held that the Co-Operation Agreement was a services agreement. The mechanical steps to effectuate the business combination were ancillary to the services that the AbbVie Board was required to perform. Thus, the subject matter of the Co-Operation Agreement was not the acquisition or disposition of property. Accordingly, the court held that the “look-through” rule of Code § 1234A did not convert the ordinary loss into a capital loss.

The Tax Court also found support for its position in the legislative history to Code § 1234A. Reports from the House Ways and Means Committee, the Senate Finance Committee, and the House-Senate Conference Committee in 1981 all state that Congress enacted Code § 1234A to make certain “that gains and losses from transactions economically equivalent to the sale or exchange of a capital asset obtain similar treatment.”^[ix]

Takeaways
While the AbbVie decision is certainly good news for the taxpayer involved, it creates substantial risks for breakup fee provisions that are not structured with such decision in mind. When obligations are service-oriented—the party obligated to pay the breakup fee is not one of the parties to the transaction agreement—termination fees may be treated as ordinary expenses, and not as capital losses.

Other breakup fee provisions could be found to have a “crux” (to quote the Tax Court in AbbVie) more toward the acquisition of stock than the provision of services. For example, would the result be same if a public company planned to acquire a domestic target through a Delaware law reverse subsidiary merger, but canceled the contract and became obligated to pay a break fee to the target? This fact pattern looks a lot more like the acquirer had contemplated acquiring the stock of the target directly and not through the adoption of a holding company structure requiring shareholder consent. Would that contract be considered to relate to property—that is, the stock of the target—and give rise to a capital loss under Code § 1234A?

In closing, we note that a break or termination fee is necessarily a deductible expense under Code § 162 simply because Code § 1234A does not characterize the payment as capital in nature. Regulations under Code § 263 require break fees to be capitalized if the payer is terminating the transaction in order to enter into another transaction.

(Heta Desai is a vice president at Davidson Kempner Capital Management.)

^{[i] 164 TC No. 10 (June 17, 2025).}

^{[ii] “To a Mouse,” by Robert Burns (1785).}

^{[iii] 2014-42 IRB 712}

^{[iv] A.E. Staley Mfg. Co. & Subs. v. Commissioner, 119 F.3d 482, 490 (7th Cir. 1997), rev’g 105 T.C. 166 (1995); El Paso Co. v. United States, 694 F.2d 703, 712 (Fed. Cir. 1982) (per curiam); see also Sibley, Lindsay & Curr Co. v. Commissioner, 15 T.C. 106, 110 (1950).}

^{[v] An abandonment of an asset is not a “cancellation, lapse, expiration or other termination of a right or obligation” within the meaning of Code § 1234A. Pilgrim’s Pride Corporation v. Comm’r, 779 F.3d 311 (5th Cir. 2015).}

^{[vi] 163 TC 76 (2024)}

^{[vii] 882 F.3d 1026 (11th Cir. 2018), aff’g 147 TC 217 (2016).}

^{[viii] 161 TC 130 (2023)}

^{[ix] H.R. Rep. No. 97-201, at 213 (emphasis added); S. Rep. No. 97-144, at 171 (using identical terms); H.R. Rep. No. 97-215, at 260 (1981) (Conf. Rep.) (“The conference agreement follows the House bill and Senate amendment.”).}